Balancing on the High Beam

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning July 5, 2016
With Market Questions and Answers

Summary Comments:

A holiday weekend shortened letter. Happy 4th!!

Prior week’s investing activity: Very active in shorting and moving pieces around the board. Rise in precious metals and the equity market after Monday provided new opportunities to invest based on market metrics that favored longs and shorts. The week’s returns and overall performance were very good, with the double digit ROI threshold for my portfolio exceeded for the first time this year.

My portfolio’s YTD performance vs the market, and its current composition as of July 1, 2016, are as follows:

Connolly Portfolio YTD gain as of July 1, 2016 equals + 10.25%
S&P 500 Index YTD gain as of July 1, 2016 equals + 2.89%
NASDAQ Index YTD loss as of July 1, 2016 equals – 2.89%

The Portfolio’s composition as of July 1, 2016 is as follows:
• Cash 43.9%
• Equities 37.2%
• Gold 15.7%
• Fixed Income 3.2%

Forecast for the coming week: Market has been on a roll higher since last Monday’s losses, recovering all of the declines from BREXIT. This buy-the-dip behavior will not end well. I am building new short positions to prepare for a market resumption of declines. Healthy positions in cash are advisable.

Market Questions and Answers

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

Everybody joined the party but the equity indexes and transports are all reaching points of upper resistance. The Dow Jones Industrial Average, the S&P 500 Index, the NASDAQ index and the Dow Jones Transports are all in a downtrend channel even with the past week’s rise.

Relative Strength: I do not see the market as being resilient in its current state, and the level of up and down points in the RS index are offsetting.

Price Earnings multiples are close to 24.31X for the S&P 500 and 19.19X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT rose nicely but remains in a declining chart pattern. It has been a leading indicator of the broader market. The continued selling of the Transports is a strong negative for the overall market.

The DJU has moved to a new high as investors seek yield reflecting the cautionary investing strategy of a market that poses greater risk then reward for investing in growth oriented businesses. Safety is being sought.

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 134. As an FYI, 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 -134 reading indicates an expensive market. The highest negative reading here was -182 on November 6, 2015. The strongest positive reading was +28.5 on February 12, 2016. Last year at this time (July 3, 2015) the reading was -115, which foretold the summer of 2015 declines in equity prices. We are at a similar place with declining cash flow estimates for the year occurring when high current multiples characterize the market.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 18.91X. This is a relatively high reading of price to cash flow when compared to the historic median of 16.96X. This is getting closer to an extreme overvalued market (19.72X was last extreme point before a sell-off). The expectation of earnings and cash flows are falling in a market that desperately needs improving operating performance to justify its current value. This does not bode well for equity price appreciation from this point forward.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 73 companies were priced above their DCF value which exceeds the historic average of 61 for the portfolio. This supports an expected fall in the market as more companies have become overvalued and need to correct lower.

The dollar spread between the Current Price and the Discounted Cash Flow price utilizing 2017 cash flow projections on the 187 Portfolio Companies is now at $16.20. The difference or spread today is below the historic median of $22.38. A higher spread indicates greater value to invest in whereas a lower spread indicates subpar returns will be realized from investing at current prices. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces potential gains absent a significant improvement in future earnings and cash flows.

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

The week’s volume and issues continue to reflect divergent views.

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

The daily metrics of (1) index point moves being supported by the daily advancing or declining volume, and (2) the index point moves being supported by the daily rising and falling number of issues traded, appear to be in a transition stage from being directionally upward in nature to more neutral.

Where are the New Highs and Lows moving toward?

On Friday we reached a total of 411 New 52 week highs for the day. Very positive reading, but in the context of the past 52 weeks, this is logical given the move in the indexes and the proximity to new index highs.

How well are Market Tells correlating with Market trading internals?

The technical market internal indicators and the Market Tells are not in alignment. This is an indication of volatility that needs a resolution one way or the other.

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

The reading is -7. This score reveals a market that is turning lower, one that is showing bear market tendencies in the face of expensively priced stocks and bonds, poor economic results, and a world of increasing political uncertainty. The range is from +7 to -7 and we are at an extreme negative level. Contributors are:

Negative in the following areas:
Calendar
Environment
Duration
Action
Trend
Emotion
Valuation

Positive in the following areas:
None

Neutral in the following areas:
None

Other:

Bitcoin rose this week to $671 per coin. The continued volatile movement in this digital currency is telling us something important. I believe it is the economic and political turbulence in world markets that is creating buying and selling here, and it reflects a foreshadowing of greater uncertainty and loss of confidence in the Central Banks of the world. Something is happening in the alternative currency sphere that should not be ignored in terms of the implications for the broader financial markets. The per unit value based in the low $400 area over the past four months. Over the past year, the price has increased by over 200% from the $230 area. I hold a position in Bitcoin as we move closer to digital currencies vs paper money and coinage. Please note I also own stock in the company PayPal (symbol “PYPL”) and Square (”SQ”) given the success and reach of digital online payment platforms.

The Dollar Index now sits at 95.64. Over the past twelve months it has traded between 93 and 100. The dollar has appeared to be range-bound in this area. The latest global economic data failed to indicate economic improvement in the United States and in other geographies throughout the world. We should see the US Dollar act as a safe haven.

Gold closed the week at the $1,340 per ounce. The global phenomena of negative interest rates on sovereign debt in many parts of the world are giving support to the price of Gold. In the past week, the Gold and Silver Miner equities rose meaningfully, but less then I would have expected. I believe there is much more room to the upside for these equity holdings. Given the continued global uncertainty and currency volatility issues that exist, I do see material price increases for gold and silver in the foreseeable future and for Gold to advance much higher above the $1,300 level. I will therefore maintain my PM positions to offset potential equity price declines from the broader market.

The Ten-year bond yield dropped dramatically and closed at 1.44%. We are now at the low yields last seen in 2012 (1.64%). The economic signals I see from the latest government releases show an economy that is contracting. The behavior of the Bond market is confirming that economic slowness. Of concern is a flattening of the yield curve (recession) and the absence of economic activity that a steeper yield curve, if we had one, would indicate. Again, the safety trade of the US is a dominant theme, and yields may fall further as the safety and liquidity of the U.S. market is sought.

Commodities: This week we saw the CRB commodities index remain flat. The softness in economic demand factors and the rise in the value of the U.S. Dollar are negatives for the pricing of Oil and the Industrial commodities.

The High Yield vs Investment Grade spread contracted in support of a rising market and a risk-on trade. We closed this week at a spread of 4.059% and the indication was to take risk-on. Over the past two weeks the range has been 3.94% to 4.352%. High Yield is at 6.768% and Investment Grade is at 2.709%. If the oil market holds the price of a barrel near the $50 mark or higher, the health of high yield market should continue to improve. 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 week.

As always, 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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