Be Wary of the Siren’s Song

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning April 25, 2016
With Market Questions and Answers

Summary Comments:
If I had a dollar to invest today where would I put it? The growing crowd is telling me to invest in the equity market.
Should I follow the crowd, my instincts, or should I look to history for guidance?

The crowd is moving more together then since early February when everyone was running for the exits. Now they are running into the building. The overall Market Bullish sentiment readings reveal a bullish bias for higher market prices. The Consensus Index of Bullish sentiment is presently at 66%. Higher prices are anticipated and the recommendations of investment advisors is to put more money to work in the equity markets. The flow of money into advancing stocks which is being confirmed by the daily and weekly advancing volume and the number of advancing issues is like the Siren’s Song. The money is moving into stocks. These facts indicate that I should take my dollar and buy stocks.
But wait, what is it about my education and the lessons found in Greek mythology that seem to nag at me? Ah, yes, it is the Sirens who were beautiful yet dangerous creatures, who lured nearby sailors with their enchanting music and voices to shipwreck on the rocky coast of their island. Is that the theme of today’s song?

My instinct tells me to wait. I like to follow the crowd when it is possible to be near the front of the line, not at the back of the line. I have a preference for the best seats in the house, and they come with being early. My instincts tell me it is late to get on the line even though everyone seems to be in agreement that the show is worth the admission, even for a bad seat. So, I am choosing to not follow the crowd today. I do need to do something else with this dollar in an environment where no one wants to borrow my dollar and pay an interest fee that would make me happy. Do I just stick it under the mattress? Will that make me sleep better at night? A dollar that stays a dollar with no opportunity to make a return means I will only have a dollar in the future, and if there is inflation, it will buy even less than it can buy today. My instinct wants safety, and maybe that is more valuable to me today than the alternatives. Yes, my instinct votes for the mattress, but what does history tell me to do?

History is telling me to revisit past times when we approached turning points or continuation points. I want to know if the odds based on past performance are indicating that we are closer to a turning point in the market or to a continuation pattern?
After reviewing many aspects of the market, the continuation view wins, but I have to add that the market is not presenting enough of a reward to compensate for the risk. Commentators are downplaying the risk as they opine on how resilient the market has been as it digests and continues to move forward even with less than robust news from its leaders such as Google (Alphabet), Microsoft, JPMorgan, Goldman Sachs, Caterpillar, etc. Climbing that wall of worry is the refrain I seem to be hearing a lot of lately. I question the resilience that is being touted because I am convinced that one meaningful piece of bad news will begin a fast unravelling of the advances made since February, and the degree of potential decline far exceeds the degree of potential advance. Why do I see the weighting to the downside? Because, in terms of value, the potential prize to the upside is dwarfed by the potential pain to the downside? The analysis I just completed sites eleven points of a turning point to the downside and eight points of a continuation to the upside. The upside wins because of the overwhelming positive sentiment that is present today. However, when you read the points which I will detail below, I believe the best conclusion is to let sentiment have its day and to trust in value as the ultimate decider of future market behavior. Today value is stretched like that very wound rubber band, and when it snaps it will do so with speed and velocity that will not give time to get to the exits before losses become untenable. If I am right, then my lack of participation in aggressively investing in this market now will enable me to be there after the declines with available capital to invest in true value opportunities that will provide long-term growth and enhanced returns on that dollar. Today that dollar will remain in a state of preparedness as it waits in the mattress, in some gold, and in some strong dividend paying companies.

Continuation Factors
• Leading economic indicators are rising
• Equity indexes have broken through upward band resistance points
• Rising commodity prices and improvement in freight shipping rates support expectations of improving economic conditions as demand increases
• The Dow Jones Transports is in an uptrend, reaching some near term resistance, but nonetheless in an uptrend. If it continues this bodes well for economic expansion
• The Dow Jones Utilities has pulled back by 5% indicating money is leaving a safe haven and is seeking higher returns by taking on higher risk with a greater degree of confidence in positive outcomes
• New Highs, Advancing Volumes and Advancing Issues all support rising index values
• The spread between dividend yields and bond rates is under 1%, thereby supporting the movement of investment dollars into equities
• The improvement in crude oil prices and commodities has mitigated fears of disruption in the energy sector and in the high yield market
• The spread between High Yield and Investment Grade credits has narrowed appreciably indicating a reduction in perceived market risk which supports higher equity prices.
• Sentiment is bullish and market participants view the overall market as favorable for taking on additional risk as the Central Banks provide liquidity and a low cost of capital

Turning Points
• The percentage change in earnings is falling behind the percentage change in equity prices. Since December 31, 2015 earnings have lagged price performance by over 8%.
• The Price Earnings ratios are all well above historic averages, and that includes the ratios based on current earnings, forward 2016 earnings and forward 2017 earning projections.
• The NASDAQ has been underperforming the S&P and the DJIA based on weekly comparisons going back to September 2015. As the NASDAQ reflects a meaningful share of the growth oriented companies and technology, this does not bode well for future growth of the broader economy.
• The equity indexes have not had a 3% down move in ten weeks. Over that ten-week period the indexes are up in excess of 12%. The historic averages for time of continued upward moves and for increases during that period are 9 weeks and 9%, respectively. So we are above the historic averages for the length of time for a continued advance higher and for the amount of the increase realized during that period.
• Dollar weakness has resulted in the dollar reaching historic based inflection points. Given the relative favorable interest rate returns in the US and the better performing equity market, it is likely that the demand for dollars will strengthen from its recent lows and by doing so put pressure on emerging markets and the overall global economy.
• The DJIA, S&P 500 and NASDAQ indexes are all at levels equal to upward resistance points in a downward channel. If they fail here the pullback may be significant.
• The cumulative up points for the indexes over the past 12-weeks are at historically high levels, levels that generally presage a market reversal to the downside.
• Some of the key growth companies have recently reported growth rates that are below their historic averages
• Bonds are favored over equities when combining the historic readings of equity market volatility to today, cash flow growth to today, and cash flow multiples to today, against the spread between dividend yield and bond yields.
• The comparison of Enterprise Value (Market Value of equities plus the net debt) to EBITDA (annual cash flow generated) results in a multiple that is near the top of historic peaks. This typically indicates an overvalued market with limited upside price potential.

Given the above, who should we listen to? The crowd, our instinct, or history?

It should not come as a surprise that I did nothing this week in terms of buying or selling risk assets. My portfolio’s performance for the YTD period and the resulting period-end portfolio asset allocation is set forth below.

The portfolio and market performance for the YTD period ending on April 22, 2016 is as follows:

YTD Connolly portfolio gain as of April 22, 2016 equals +6.11%
S&P 500 Index YTD gain as of April 22, 2016 equals +2.33%
NASDAQ Index YTD loss as of April 22, 2016 equals -2.02%

Portfolio composition as of April 22, 2016 is as follows:
• Cash 51.1%
• Equities 34.9%
• Gold 12.4%
• Fixed Income 1.6%

Forecast for the week: This coming week will see some market moving earning announcements. These include Apple and Facebook. The expectations for Apple are very modest given its product release cycle. For Facebook the growth is expected to be very meaningful to continue to support the high multiples that FB trades at (79X cash flow vs a market average of 18.13X). As a backdrop, the reported weaknesses we saw in the earnings’ announcements of some very important companies, whether that be in Tech, the Financials, or the industrials, may begin to take their toll if the results from other companies continue to point to modest or below trend rates of growth. Apple and Facebook could be catalysts here.

For the week I anticipate the weight of the recent market rise coupled with the less than robust revenue and earnings’ releases to begin to pressure the market to the downside. Further, the coming FED meeting and the macro-economic and market results from the key territories such as China, Japan, and the European region may add pressure to the market’s advance. Couple this with the recent noise on Greece again and the looming vote in Britain on BREXIT, and the recipe for a turbulent and declining market gain traction. I will look to keep my E-Mini short in place and to monitor the precious metals market for signs that fear may reassert itself on the investment scene.

Market Questions and Answers
What are DJIA, DJT, DJU, S&P and NASDAQ metrics indicating?
All of the indexes appear to be in topping patterns of one sort or another. The consistency, whether in Relative Strength readings north of 70, earnings multiples north of 20X for the S&P and approximately 19X for the DJIA, and chart patterns that reveal resistance to further moves higher, indicates meaningful risk to putting additional capital to work in equities.
The DJT continues to lead the market trend up. It is at a resistance point and if it can break higher it would be a positive sign for the overall market.
The DJU has had a meaningful correction down of approx. 5%. It continues to reflect the safety of yield in a nervous world of Central Bank easing and Negative interest rates on foreign government debt. Profit taking dominated the action this week, and it also served as a source of liquidity to move funds into more aggressive equity holdings.

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 41. 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 18.13X as compared to last week’s 18.32X. 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 71 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. 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 $18.72, pulling back from the February high of $25.14. This narrowing spread indicates that future performance has been pulled into the current pricing in a manner that reduces potential gains in the future.

What is the position of the net up down Vol/Issues?
The week’s volume and issues were strongly aligned with the index point rises. New highs are also indicating a broader participation. The market’s internals are very well aligned with continued market support from money moving to risk on assets versus risk off assets.

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 daily volume in rising and falling issues, and (2) the index point moves vs the daily 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 309 new highs over new lows. The strength here is very supportive from a technical perspective, but an improvement of earnings and cash flow are needed to provide support that these new highs are sustainable over time.

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 continuation of the rise in value, while the Fundamentals point to a longer term valuation issue. If the valuation concerns begin 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 +1 as compared to last weeks’ assessment of zero. Contributors are:
Negative in the following areas:
Environment
Valuation
Duration
Positive in the following areas:
Calendar
Action
Trend
Emotion
Neutral in the following areas:
None

Other:

Bitcoin is at $449 per coin and is showing stable growth development. The per unit value based in the low $400 area over the past month but this week it advanced more than 5%. Over the past year, the price has increased by roughly 100% from the $230 area. I hold a position in Bitcoin as we move ever closer to digital currencies vs paper money and coinage. Please note I also own stock in the company PayPal (symbol “PYPL”) given the success and reach of its online payment platform and, in the mobile space, its penetration of the Millennial generation with the Venmo APP platform on mobile devices.

Gold closed the week at the $1,243.25 per ounce price. Continued currency weakness and Central Bank actions to keep interest rates at low or negative levels is supporting the price of Gold. Additionally, China continues to purchase meaningful quantities of Gold and just launched a Gold trading vehicle priced in their local currency vs US dollars. The price action and the demand for equities of Gold and Silver mining companies is very strong. Many of these companies have more than doubled in price since the beginning of the year.

The Ten-year bond yield closed at 1.89% and has risen meaningfully over the past two weeks (off the low for the calendar year on April 8 at 1.72%, but still below the 2015 year-end rate of 2.27%). Our Central Bank is weighing when to institute another increase in the Fed Funds rate, and the recent back-up in rates and the late week rally in the value of the dollar indicate an increase is coming closer to being enacted from a calendar perspective. At some point this will likely weigh on the equity markets as the cost of US dollar financing rises and the ROW reacts to the monetary tightness of the US and the lower liquidity that this engenders in foreign markets.

Commodities: For the week, the CRB index of commodities rose to its highest level since July 2015. This helps the Emerging Markets navigate the economic challenges of being resource providers to the world markets. With higher raw material prices in the world markets they can sell their natural resources at better prices and thereby support the social and economic needs of their countries at a more comfortable level. As a precautionary note, I should point out that we have reached a period over period increase in the CRB Index that historically has tended to indicate a subsequent deceleration of price advances. Any strength in the dollar and associated rise in US interest rates will likely cap any future price increases here.

The High Yield vs Investment Grade spread has continued to contract in a way that reveals high demand for yield while accepting greater risk. Clearly the increase in the price of crude oil has been interpreted as a lifeline for many highly leveraged companies. This may prove to be too much too soon, and I advise all to maintain a constant awareness of the moves in oil as this price impacts many companies’ ability to service their debt. Any bumps in the road here in terms of oil price declines could easily spill over into the broader market with nasty downdrafts in overall equity pricing.
The spread between HY and IG bond yields closed on Friday at 4.4% which is down from 6.24% on Feb 16, 2016. The HY closing quote on Friday was 7.391% vs 9.62% on Feb 16. The Investment Grade close of 2.991% compares to 3.50% on Jan 6, 2016. These are all positive moves for the market that have occurred recently. They indicate that investors presently assess there is less risk in the market.

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.

Leave a Reply

Your email address will not be published. Required fields are marked *