Separating the Wheat from the Chaff

Tom Connolly’s Equity Market Forecast

for the upcoming week beginning April 11, 2016

With Market Questions and Answers

Summary Comments:

My sense of risk vs reward is one where I believe the risk is much greater than the reward.  Accordingly, I was a net seller of equities and fixed income this past week, locking in gains and further increasing my level of cash.  The equities I sold do not reflect a view that they are fully-valued or over-valued.  I think they have much higher highs in their future, but it is my belief that the odds favor a near-term overall market decline.  That belief requires me to pair back the companies I see great value in for they will be bought back again, but at prices that are lower than today.  

There are many reasons why I am moving to the near-term bearish side.  A couple of data points will highlight my concern.  The companies within the 187 Equity Portfolio closed on Friday with a strong negative indicator that troubles me.  This indicator is very simple and not formula based.  I compare the current closing price of the portfolio to prior price levels to identify periods when values are similar.   I then look to see how many of the 187 companies are lower in price given the same portfolio value.  The expectation is that the percentage of companies within the portfolio that are lower in price at each comparison date should be approximately equal given the closeness of price at those various points in time.  On Friday, April 8th, the percentage of companies with prices lower than the December 31, 2015 price was 46%.  On March 18th the percentage was 39% but the price was effectively the same.  The 46% vs the 39% at the same price level tells me something is changing, and not in a positive way.  Secondly, a similar event exists for the March 25th comparison, only here both the price and the percentage were lower than the April 8th amounts.  This should not happen in a balanced market as these measures should move in opposite directions (a portfolio price rise should be supported by a decline in the number of companies that have negative price trends, not an increase). This indicates that the broad based price increases we saw after the February declines were driven largely by short covering in an indiscriminate manner, and now the process of separating the wheat from the chaff is taking place in an environment where there is great global uncertainty.  It is a dangerous combination, particularly when the current market value metrics indicate the market value is above the historic means and medians.  While the above summarizes my overriding sense of caution, it is very important to note that the market internals over the past week and in fact over the past two weeks do not support a continued decline.  In fact, they are pointing to a reversal of the index decline from this past week.  Conflicting signals are a regular part of the market, and that is why it is hard to truly generate above market rates of return.  With such conflicting signals the need to act prudently is paramount if we are to achieve success in these financial markets.

Given this perspective, the actions I took this week are reflected in the portfolio performance and the resulting period-end portfolio allocation that is set forth below.   The portfolio and market performance report for the YTD period ending on April 8, 2016 is as follows:

 

YTD Connolly portfolio gain as of April 8, 2016 equals        +5.55%

S&P 500 Index YTD gain as of April 8, 2016 equals              +0.18%

NASDAQ Index YTD loss as of April 8, 2016 equals              -3.13%

 

Portfolio composition as of April 8, 2016 is as follows:

  • Cash                       52.0%
  • Equities                  34.6%
  • Gold                        11.6%
  • Fixed Income           1.8%

Forecast for the week:   First quarter earnings announcements will begin this coming week and will continue over the month of April.  The first quarter 2016 U.S. economic data has been weak, and the continued recessionary pattern of factory data coupled with disappointing data on Wholesale and Retail sales should begin to weigh on the market.  Actions by Central Banks are consistently providing smaller and smaller benefits, and the Financial Sector lacks any catalyst to support the overall market as interest spreads and IPO/Deal activity are not providing any earning acceleration.  In fact, the interest rate environment and the lackluster capital raising activities have created an earning deceleration event within the market.   Given the above, I believe we are moving to a place where the expectation of a cathartic move is once again an appropriate consideration in the development of a successful investment plan.  I say this because if we are to bring order and alignment back to market values, values that are fairly based on realized and prospective performance, then the market needs to re-establish an investible base from which to grow that is consistent with historic rates of expected return.  The first quarter revenue and earning reports will most likely show negative growth, and while these reports provide a backward looking assessment, the forward look is likely to be troublesome given the expected modest to down growth forecasts that will accompany the first quarter reports.  Additionally, the recent negative behavior of the Dow Jones Transports, an Index which has provided advance notice of broader market moves higher and lower over the past year or so, is foretelling a continued softness in economic growth.  All of this coupled with the continued weakness in global markets provide the backdrop for my assessment of high risk in the current equity market.

In this environment I continue to maintain an E-Mini short position, and will look to increase it if I continue to see the market weaken.  I have a healthy allocation to precious metals primarily through holding equites in the Miners.  The Miners have more than doubled in price since the beginning of the year and the momentum continues to be in place (the position is partially hedged with inexpensive put options).  Finally, I maintain an array of strong dividend generating equities. 

For the upcoming week, I expect volatility and uncertainty to become more pronounced.  The overall market pattern indicates to me that the market move higher is tiring, and that the tilt of the market is to the downside which may accelerate quickly.  The highflyers of Amazon, Netflix, Facebook, Apple and Google will be tested this quarter.  The damage done in the bio-tech and healthcare space is not over, and has not been helped by the United States Treasury ruling on M&A tax inversions and earning stripping tactics of foreign based companies.  I think this ruling has not been fully absorbed by the market in terms of its depressing effect on M&A, and this may be the catalyst that once again sees government actions and regulation undermining the growth opportunities of the companies comprising the most meaningful value areas in the marketplace.   My conclusion: “Be very careful out there”. 

 

Market Questions and Answers

What are DJIA, DJT, DJU, S&P and NASDAQ metrics indicating?

The DJIA, NASDAQ and S&P remain in over-bought territory, but the decline in the past week took some of the excess out of the market.  The 12-week Relative Strength readings are 75 for the DJIA, 71 for the S&P, and 67 for the NASDAQ (RS in the 30s and below typically indicates an oversold market and hence a buying opportunity, while north of 60 typically indicates overbought conditions and a selling opportunity).  It makes sense to expect a continued market pullback as the Relative Strength loses upward momentum and gravitates back to a more balanced or even over-sold condition.  In isolation, I would be mindful of the RS level but not use it as the decisive indicator for investment actions.  But at these valuation levels, and with the troublesome macro-events taking place, market sentiment could turn quickly, and if it swings to the negative side, the declines could accelerate in an abrupt manner.   This makes me more sensitive to the RS level in making investment decisions that are strongly influenced by the likelihood of the market being near a turning point.

The DJT continues to lead the market trend.  It peaked on March 18th, and for the past three consecutive weeks it has declined.  As I wrote last week, the DJT is often the canary in the coal mine, so pay attention to the daily/weekly changes here. 

The DJU continues to be strong reflecting the safety of yield in a nervous world of Central Bank easing and Negative interest rates on foreign government debt.  It did pull back this week as the run higher has become extended.  Profit taking dominated the action.  Keep an eye on this index as it presently gives an indication of investor pursuit of safety rather than economic expansion (economic expansion would be evident if electric usage was accelerating thereby driving Utility profitability, and electricity consumption is not expanding at this point).

 

What is the current score on the Market tells metric?

The Market Tell indicator, which is a comparison of the market’s current cash flow and valuation metrics to its historic medians, closed the week at negative 31 as compared to last week’s reading of negative 58 (meaningfully lower than its high reading of +44.8 when the market made significant lows on February 12th).   When we have a high positive reading this is a strong buy signal and when we have a high negative reading it is a strong sell signal.  The Portfolio’s Cash flow multiple based on expected 2016 full year results is 17.97X as compared to last week’s 18.44X.  These are relatively high readings of price to cash flow when compared to the historic median of 16.8X.  Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 68 companies were priced above their DCF value, which exceeds the historic average of 60 for the portfolio.  This supports an expected fall in the market as more companies have become overvalued.  I should note that at December 31, the number of companies in this category totaled 72 prior to the January decline.  The dollar spread between the Current Price and the Forward DCF price utilizing 2017 cash flow projections on the 187 portfolio has narrowed and is now at $19.40, pulling back from the February high of $25.14.  Of concern is that the dollar spread based on 2016 cash flow projections is $11.43, which is below the historic median.  This indicates below trend growth in 2016, and an optimistic view for 2017.  Given the wider level of variability that comes into play the further we project into the future I am concerned that the above trend multiple of cash flow which currently exists is giving too great a weight to events that are beyond the current year.

 

What is the position of the net up down Vol/Issues? 

The week’s volume and issues were contra-indicators.  This is important to discuss and to assess its implications.  The market indexes declined this week in a manner that was NOT supported by the declining volume and the number of declining issues.  In fact, the volume and issues point to a coming reversal of this week’s declines in the indexes.   A bit of a quandary here.  In fact, this behavior makes me cautious in being too aggressive on the short side.  As a result, I do not plan to increase my short exposure based on the current facts, but will monitor these two elements more than any other in the coming days and weeks to either add support to my bearish thesis or to tell me to reverse course and get more aggressive on the long side. 

 

What are the daily point vs issues and point vs volume measures indicating up or down? 

The daily metrics of (1) index point moves vs the volume in rising and falling issues, and (2) the index point moves vs the rising and falling number of issues traded, were consistently positive and supportive of a market that should move higher.      

 

Where are the New Highs and Lows moving toward?

Confirmation of a positive trend continues to be evident as New Highs are on the rise.  Actual net new highs for the past five days came in at a cumulative net of 484 new highs over new lows during a week when the market indexes went down.  Similar to the discussion above on Volume and Issues, this is counter to the overriding view I have that the next move will be lower.  Need to be careful here.

 

How well are Market Tells correlating with Market trading internals?

Technically, the 5-day activity in volume and issues is supporting rising prices.  The fundamentals of the Market are indicating a different story. From a trading perspective the technical attributes of the market point to a short term continuation of the rise in value, while the Fundamentals point to a longer term valuation issue that I believe the market is getting close to acknowledging, particularly when current earnings for the first quarter and forecasts for the balance of the year come out during April.  If the valuation concern begins to dominate trading, the technical indicators will quickly flip from positive to negative.  Time will tell if this view has merit.     

 

What is the composite reading of the Calendar, Environment, Duration, Action, Trend, Emotion and Valuation (“CEDATEV”)?

The reading is -3 as compared to last weeks’ assessment of +1.   Contributors are:

 Negative in the following areas:

Calendar

Valuation

Duration

Trend

Positive in the following areas:

Action

Neutral in the following areas:

Environment

Emotion

Other:

Bitcoin is at $418 and continues to show stability.  I hold a position in Bitcoin as we move ever closer to digital currencies vs paper money and coinage.  Please note I also own PayPal given the success and penetration of the Venmo platform. 

Gold was volatile on the week and showed an improving trend as it closed the week in the $1,240 per ounce area.  Miners were up meaningfully, breaking prior resistance levels in a trend that looks like it will continue. 

The Ten-year bond yield closed at 1.72%, down from 1.78% last Friday.  The Fed’s dovish commentary and the relative spreads between US rates and foreign rates continues to exert downward pressure.  Additionally, the relative weakness in the dollar is contributing to the downward move in yields and the upward move in commodities.  For the week, the CRB index of commodities rose to its highest level since September 2015, and this helps the Emerging Markets navigate the economic challenges of being resource providers to the world markets.

The High Yield vs Investment Grade spread continues to be supportive of rising equity values. The spread between HY and IG closed on Friday at 4.924%. The HY closing quote on Friday was 7.885% vs the Investment Grade close of 2.961%.  These are all positive moves for the market that have occurred over the month of March into April.  The debt market is indicating that the higher expected rates of default is now lower than what was previously thought.  If accurate, that is a positive sign for the market.  We do need to keep an eye on developments in the oil patch for any re-emergence of HY concerns and potential spillover into the broader markets.  Presently, there is support for crude oil priced in dollars as the dollar weakness provides a backstop.  Actions from OPEC and the decline or increase in the number of operating rigs in the US remain key to future price movements. 

Have a great week!

Tom

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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