Deja Vu

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning Aug 15, 2016
With Market Questions and Answers

Summary Comments:

I keep a personal diary that captures my feelings about the market. While I write in it often, it is not an everyday event. The other day, as I look back, the words I wrote seem to be the right words for the Summary comments in this weeks’ blog post. So, without further comment, this is what I wrote on August 10, 2016:

“My thoughts and feelings are very mixed. The losses I have incurred from my short positions are large. Fortunately, the gains from my precious metal positions have exceeded the losses on the shorts, providing an overall 11% YTD gain. I am tormenting myself over keeping the short positions. By every measure I track and look to over time to determine points of extreme excess or opportunity, today we are as exposed as ever at a point of irrational heights. Yet the market dynamics of high/lows, of advancing volume and advancing issues all confirm the move higher. A conundrum.

Do I keep the shorts in place after suffering such extreme losses?

Do I liquidate the precious metals after enjoying such extreme gains?

Why have valuation fundamentals become so disregarded by the market?

I am struggling to choose a path.

Best case scenario for my portfolio would be:
1) A serious market correction
2) A continued rise in precious metals

Worst case scenario for my portfolio would be:
1) A continued rise in equity indexes
2) A large decline in precious metals

What do I believe are the odds of each scenario happening?
1) Best Case:
a. Market correction in the current environment 25%
b. Gold and Silver going higher 65%

2) Worst case:
a. Market continues to rise 35%
b. Gold and Silver drop meaningfully 20%

3) Fill to get to 100%:
a. Market is flat 40%
b. Gold and Silver consolidate 15%

Given this perspective, I am going to hold my positions.”

As always, be careful out there.

Prior week’s investing activity: Last week was very much steady as she goes. I trimmed a small amount of the Gold mining position to take some profits off the table, added a little to the S&P September put option holding, and otherwise was very inactive.

My portfolio’s YTD performance vs the market, and its current composition as of Aug 12, 2016, are as follows:

Connolly Portfolio YTD gain as of Aug 12, 2016 equals +10.20%
S&P 500 Index YTD gain as of Aug 12, 2016 equals + 6.85%
NASDAQ Index YTD gain as of Aug 12, 2016 equals + 4.50%

The Portfolio’s composition as of Aug 12, 2016 is as follows:
• Cash 51.7%
• Equities 28.3%
• Gold 18.0%
• Fixed Income 2.0%

Forecast for the coming week: This coming week is the anniversary of last summer’s dramatic decline. The market metrics of July 2015 and July 2016 are twins, and not that last year should guide this year, but the level of overvaluation today is even greater than last year. Best to be careful. For the upcoming week I do not see any driving news or events that will change course. Presently, we have been in a rising market that lacks drama, so my view is to be careful and to not be complacent as this walking on a tight-rope is not for the weak of heart. Being ready to act is paramount as the current market move higher is approaching a length in time that often reflects fatigue and a need to rebalance through a correction.

Market Questions and Answers

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

New index highs dominated the headlines last week (S&P 500, NASDAQ and DJIA), a triple that last happened in the year 1999. The DJU and the DJT did not attend the party and should be kept in our peripheral vision as a cause of potential concern. The trend in overall equities remains higher, but not in a rational way.

Relative Strength: We are in overbought territory on the RS indicators. The DJIA reading is 72, the NASDAQ reading is 75, and the S&P reading is 74. The NASDAQ has moved higher for seven straight weeks. The continued advance has stretched valuations like a rubber band, and any continued move higher will only serve to add tension and power to a potential snap-back event in an overbought and over-valued market.

Price Earnings multiples are 25.27X for the S&P 500 and 20.24X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT remains in a declining chart pattern. It was modestly down this past week while the broader equity indexes rose. It has been a leading indicator of the broader market these past two years and should be watched closely for confirmation of a move higher or indications of a reversal in economic fortune.

The DJU has been churning over the past four weeks around 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.

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

HAZARDOUS WARNING:

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 214. 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 -214 is the highest negative reading I have ever seen. Some of the components are at levels that are scary in regard to over-valuation.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 20.06X. This reading of price to cash flow is the highest reading over the past ten years. If we were experiencing continued rises in growth of future cash flow estimates and rates of growth in cash flow generation then one could justify the high current multiples. However, we just reached the lowest level of cash flow growth projections for the year, now at only a 0.61% growth YoY (August 2016 vs August 2015), and for the full year 2016 vs 2015 the growth is projected at only 1.58%. At some point in time this rising price environment in a declining cash flow growth environment will break.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 84 companies were priced above their DCF value. This is a new record high of the percentage of the portfolio that is trading above their discounted cash flow values. The 187 company portfolio’s historic average of prices above DCF is 61. This warns of an expected fall in the market as more companies are overvalued and will need to correct lower to create a more attractive risk reward profile.

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 $12.29. This is based on a projected cash flow increase in 2017 over 2016 of 13.09%. The difference or spread today between the current price and the DCF price is the lowest in my tracking history and is meaningfully below the historic median of $22.13. 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 have faded in terms of validating the index point moves higher. Of particular note is that the weekly average volume totals are falling to levels unsupportive of the level needed to confirm the strength of the index point moves higher. Declining volume in a rising market is troublesome. This is after taking into account the seasonal phenomena of the summer in the city doldrums and the migration to the beach.

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

The daily trend is supportive but in a lessening manner. 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, confirmed the support for the market.

Where are the New Highs and Lows moving toward?

The momentum in new highs vs new lows appears to be tiring. We are seeing a static number of new lows, and a declining level in new highs (note daily new highs are happily in excess of new lows, so there is confirmation of the underlying participation of the broader market in the rally higher, but the gap is shrinking over the past two weeks and warrants paying attention to in regard to whether the participation is beginning to narrow).

How well are Market Tells correlating with Market trading internals?

The technical market indicators and the Market Tells of valuation are not in alignment. This is an indication that future volatility will arise to bring about a resolution of this imbalance. As we continue to extend gains the level of risk for a dramatic decline to adjust the price of the market to the cash returns from the market becomes increasingly dangerous. Close attention needs to be paid to exogenous events that could ignite a market reversal.

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

The reading is minus 2 (-2). This score reveals a market that has many competing influences. The world events and economic trends coupled with an expensively priced group of stocks and bonds pose significant risk, but the emotion does not show a reversal to the downside.

Contributors are:

Negative in the following areas:
Duration
Trend
Valuation

Positive in the following areas:
Emotion

Neutral in the following areas:
Calendar
Environment
Action

Other:

Bitcoin weathered a storm brought about by the hacking of a Hong Kong based exchange and the theft of millions of dollars of Bitcoin. The price per BTC fell to the mid-low $500s before moving to its current level of $573. 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.

The 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.

Gold closed the week at the $1,341 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. Over the past month, the Gold and Silver Miner equities have risen materially. Results for the quarter ended June 30 were very good, and the action in the $1,300 per ounce area does not show signs of any meaningful pullback. 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 (with modest sized exits and entrances to capture periodic swings above or below a normalized trend) to offset potential equity price declines from the broader market.

The Ten-year bond yield weakened a bit this week and closed at 1.51%. The economic signals I see from the latest government releases show an economy that continues to operate in a very modest way, often presenting signs of continued slowing. The behavior of the Bond market is confirming that economic slowness. Of concern is a flattening of the yield curve (recession) with only slightly more than a 1% spread between 3-month money and 10-year money.

Commodities: This week we saw the CRB commodities index stabilize. 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 contracted to give further support to the no-fear environment and the aggressive pursuit of risk for yield. We closed this week at a spread of 3.484% and the indication was to take risk-on. High Yield is at 6.124% and Investment Grade is at 2.64%. If the oil market fails to hold the price of a barrel near the $45 to $50 mark or higher (right now we are rallying to the $45 per barrel mark), the health of the 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. However, right now the HY arena is backing a continued commitment of money to the market.

That about covers it.

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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