“An Investor’s Point of View”

Year-to-Date returns and Asset Allocation of the Connolly Portfolio
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An Analysis of U.S. Equity Market Fundamentals and Technical Indicators
September 17, 2016
by TJ Connolly

SECTION I

The Connolly Portfolio’s YTD performance vs the market, and its current composition as of September 16, 2016, are as follows:

Connolly Portfolio YTD gain as of September 16, 2016 equals + 5.05%
S&P 500 Index YTD gain as of September 16, 2016 equals + 4.66%
NASDAQ Index YTD gain as of September 16, 2016 equals + 4.74%

The Portfolio’s composition as of September 16, 2016 is as follows:
• Cash 55.2%
• Equities 22.3%
• Gold 20.5%
• Fixed Income 2.0%

The portfolio suffered over the past month given the relatively large percentage decline in the Gold and Silver miner equities that I hold in the Connolly Portfolio. The collective decline in the Miners’ share price since August 18, 2016 is 21%. That decline was the main reason the portfolio gains as of August went from double digits to the 5% noted above.

Choosing to own Gold and Silver Miner equities is not for the faint of heart as the volatility in these shares is often dramatic. Given the global dynamics at play from a political and monetary perspective, I strongly believe that continuing to hold these investments will be very rewarding over the longer term. Stomaching the recent declines is not easy, but my thesis still rings true and I continue to expect to be handsomely rewarded by this investment decision.

SECTION II

U.S. Equity Market Fundamentals and Technical Indicators

1. What are the Dow Jones Industrial Average (“DJIA”), the Dow Jones Transportation Average (“DJT”), the Dow Jones Utilities Average (“DJU”), the S&P 500 Index (“S&P”), and the NASDAQ index indicating?

Chart Trends: When charting these indexes on a weekly basis over time, we find that they are all pretty much sitting at support levels. I would not be surprised from a charting perspective to see these equity indexes bounce off of the support levels and head higher. However, this technical picture also poses the risk that should the current support levels not hold, the ensuing declines could be large. I have structured the Connolly Portfolio with a very low level of equity holdings as I do expect a material decline in the overall U.S. stock market.

Relative Strength Readings: Relative Strength is the accumulation of net changes in the individual equity indexes over a period of time. Rising markets increase RS, while declining markets decrease RS. Markets tend to move up and down in a way that present buying and selling opportunities. A rising market is a reason to buy stocks, but if the enthusiasm for owning stocks become excessive with the result that prices have risen too much, we often will see these excess levels identified by very high RS readings. The opposite is true for declining markets. RS readings above 50 indicate a rising market trend, while RS readings below 50 indicate a declining market trend. At levels above 70 or below 30, one must consider whether the buying or selling has become excessive and thereby presenting of an opportunity to profit from a reversal of the excesses. Presently, we are in overbought territory on the RS indicators, with the NASDAQ being the most at risk given its high reading. The NASDAQ reading is 83, the DJIA RS reading is 67, and the S&P reading is 73.

Price Earnings Multiples which allow a relative way of comparing how expensive or inexpensive individual stock prices may be given the earnings they generate are presently at historically very high levels. This means stocks are currently trading at high prices as compared to the earnings they generate when viewed through the lens of past performance. The current PE multiples are 24.75X for the S&P 500 and 19.68X for the DJIA. Why is this viewed as expensive on a historic basis? Consider that since 2005, the median PE for the S&P was 18.88X, while the median PE for the DJIA going back to 1988 is only 18.03X.

The DJT remains in a churning but declining chart pattern. It was modestly down this past week but maybe more importantly it broke below the recent weekly closing low of 7,807 from August 12th. It has been a leading indicator of the broader market over the past two years and should be watched closely for direction of the overall market.

The DJU has been declining since July 22nd. It did move higher this past week as the fears of an interest rate increase began to fade and investors seeking yield went back into the high dividend paying utility sector.

2. What is the current score on the “Market Tells metric”?

I developed a “Market Tell” indicator that treats a portfolio of 187 companies as if they are a single stock. This “stock” is tracked over time to provide an overall sense of whether the “187 Portfolio” is expensive or cheap, and whether there are individual components of the portfolio that present profitable opportunities. The Market Tell indicator principally compares the “187 Company Portfolio’s” current cash flow and valuation metrics to its historic medians. It closed this week at negative 220. This is a very strong indicator that future positive returns from buying equities will be hard to come by.

The 187 Portfolio’s Cash flow multiple based on expected 2016 full year results is 20.24X. This price per share as a multiple of cash flow per share represents the highest reading reached over the past ten years and compares to the historic median of 17.06X. A high multiple such as we have today would be justified if we had accelerating cash flow growth prospects. However, cash flow growth projected for 2016 over December 2015 is only plus 0.68%, basically no growth. What makes matters even more negative is that the cash flow projection as of September 2016 versus the same time last year actually shows a negative or lower cash flow level being produced (minus 1.32%).

Comparing current equity prices to their Discounted Cash Flow values indicates 84 of the 187 companies were priced above their DCF value. The DCF price is the calculation of what a company’s share price should be based on the cash flow it generates, the expected growth in that cash flow over time, and the discounting of that future cash flow by an appropriate interest rate to arrive at a current price that a willing investor should pay to own the value of the future cash to be earned by the company. The current number of companies within the portfolio that have per share prices above their cash flow value is at a new record high. The 187 company portfolio’s historic average of companies that are priced above their DCF is 61 versus today’s 84. This warns of an expected fall in the market as more companies within the portfolio are presently overvalued and will need to correct lower to create a more attractive risk reward profile.

The current per share market price of the 187 Portfolio is $75.66. The DCF price of the 187 Portfolio is $87.25 assuming an annual 13.05% future cash flow growth rate post 2016. The spread or difference in the current price and the DCF price is plus $11.59. This is a good thing, but given the level of uncertainty as to how the future will play out, it is important to consider what the historic difference or spread has been over time. Historically, the forward DCF price is $21.97 above the current price. As the outlook for the future today is no less certain than it has been in the past, the lower spread today is of great concern. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces the prospect of future potential gains from buying stocks at today’s prices.

3. Beyond the pricing of the market, what can we learn from the activity in the market as measured by the volume of shares traded, the number of companies going up or down in price, and the number of companies reaching new highs or new lows in price?

During the post-financial crisis period, I believe we have lived in an investment cycle where investment prices have been elevated through the support of Central Bank policies. Fundamentally, there has been a lack of equivalent economic strength to support current prices, but there has been interest rate reductions and Quantitative Easing policies that have channeled investment resources to equites and bonds. So while the market has appeared to be expensive by historic measures, its internal action has told a story of money flowing into stocks and bonds with the effect of raising prices as if risk was limited. It has been interesting to watch this dislocation that reflects weak fundamental values versus technical strength.

I am taking the time to write this view because something appears to be changing in regard to the technical strength. Specifically, the technical strength now appears to be fading.

Volume: There has been a meaningful skewing of volume such that greater volume is occurring on days when the market moves lower. For example, the net volume on the NYSE (total volume in advancing stocks minus total volume in declining stocks) averaged over the prior 11 days, 22 days, 45 days and 90 days, have all turned lower as negative volume is surpassing positive volume. When I couple this skewing of volume with price action, I find we have been in a declining pattern for the past year, and are presently in another leg down as greater volume is occurring on days when the market declines in an ever increasing pattern.

Issues: The ten-day average of the ratio of the number of companies rising in price versus the number of companies declining in price has now moved to the negative. This is a short-term indication that a new trend may be taking place. Further, the weekly measure of advancing companies and declining companies occurring over a look-back period of the past 49-days has also seen a reversal of trend. The 49-day average of declining issues is expanding while the 49-day average of advancing issues is contracting. This reversal began 3 weeks ago and is accelerating with more and more issues declining.

Stocks reaching New Highs and New Lows over the past 52 weeks: There is a modest expansion of New Lows taking place on a daily basis, and a more meaningful decline in the number of companies making New Highs. This is typically a sign of a market in transition, but it needs more time to play out to validate whether we are transitioning to a weaker market.

4. Other:

Bitcoin has been much less volatile of late. It is valued at approximately $606 per BC. I remain an investor in BC, buying a new coin every so often in order to slowly build a position that I believe may increase in value. There is a cap on the number of BitCoin that can ever be in circulation. Therefore, should it gain greater traction as means of exchange, and therefore become in greater demand, its value in paper currencies such as the US Dollar will rise. I found it interesting the other day when I purchased some physical Gold that the dealer accepted BitCoin as payment. It is worth monitoring. You can do so at a number of websites such as CoinBase or CoinDesk.

The U.S. Dollar Index has been consolidating in the 95 to 96 area. Over the past twelve months it has traded between 93 and 100. The dollar has appeared to be range-bound in this area. A continued strengthening could pose issues for the Emerging markets. The actions of Central Banks continue to impact the relative values of cross-currency relationships, and it is important to watch the US Dollar given its implications to trade and the pricing of various commodities.

Gold closed the week at the $1,313 per ounce. The global phenomena of negative interest rates on sovereign debt in many parts of the world is giving support to the price of Gold. The recent modest pull-back in the price of Gold in US Dollar terms is not of great concern to me at this time. However, the much more material decline in the equity prices of the Gold miners may offer a true buying opportunity. This potential buying opportunity will only prove real if the price of Gold reassumes its move higher in price. If Gold should decline further, the Miners will follow, so there is risk here that is not insignificant. Keeping a watchful eye on the actions of the Central Banks is important to this investment class of assets. Presently, the dominant view is that the CBs of the world will continue to ease and lower interest rates, as well as provide the markets with additional buying power. The US Fed is scheduled to make an interest rate announcement this week, and it may be prudent to wait to see the announcement of their interest rate decision and their forward guidance before committing new investment capital to work in this area.

The Ten-year bond yield is somewhat static and closed at 1.69%. The economic signals I see from the latest government releases show an economy that continues to operate in a very modest way, presenting signs of continued slowing. I would not be surprised to see a decline in the rate structure given the lack of economic demand and the large supplies of inventory and excess production capacity in the world.

Commodities: This week we saw the CRB commodities index soften. The softness in economic demand factors, the supplies on the market and the stability in the value of the U.S. Dollar are neutral to negative for the pricing of Oil and the Industrial commodities. Deflation remains a concern.

The High Yield vs Investment Grade spread expanded. We closed this week at a spread of 3.52% which is an increase of 52 Basis points over the past week. While still at a modest sized spread, the upturn should be watched as a further expansion will lead to a risk-off environment and a potential large decline in equity prices. The High Yield market is at 6.29% and Investment Grade is at 2.77%. If the oil market fails to hold the price of a barrel near the $45+ level, the health of high yield market may once again show pressure. A fall in oil will be problematic for the High Yield market and a general negative for the overall market.

That about covers it for this letter.

As always, wishing you great success!

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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