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.

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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