In Search of a Catalyst

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning May 23, 2016
With Market Questions and Answers

Summary Comments:

The composite view of the 187 companies I track on a daily basis is uninspiring. Operating forecasts are weak and values are expensive. Yet internal market measures are range-bound, neither high or low in offering direction for the next likely move in the overall market. Couple the market measures with uninspiring economic trends and Central Bank uncertainty, and this is what an Ebb Tide feels like.

My gut tells me the market wants to go higher not lower, yet it cannot find the catalyst to do so. If an upside catalyst does not materialize soon, the market will likely break to the downside as fatigue from hanging in this environment of thin air will force a descending move to create some breathing space.

Some facts to put a light on the character of the dilemma:

1. The Levered Cash flow growth rate over the next 3 years for the 187 companies I track is at its lowest level since right after the 2008 Financial Crisis. Current forecast is for 8.94% annual growth, which compares to over 18% in 2006, and over 10% in 2014 (it has been in a constant state of decline over the past two years).

2. The Enterprise Value (market equity value plus net debt) divided by EBITDA (earnings before interest, taxes, depreciation and amortization) is at its highest level in six years, indicating that the combined equity price plus debt is very high compared to internally generated cash from operations.

3. Earnings multiples are significantly above historic norms.

4. Interest rates are significantly below historic norms

5. The normal favorability of interest rate returns above dividend returns has collapsed in this low interest rate environment. From a yield perspective investors prefer to receive dividends from stock ownership over interest payments from debt instruments (the current yield spread is only eight tenths of one percent). This drives stock buying in search of yield.

6. The investing activity in rising stocks versus declining stocks in slightly biased to the upside but offers no clear direction that is normally found in extreme readings or turning points. Everyone is treading water.

7. Economic indicators are all slightly below zero in terms of period over period change. Minimal to negative growth is what our economy is telling us.

Prior week’s investing activity: During the past week I bought more small stakes in a number of companies, but I did not commit any meaningful capital to work. I closed and/or reduced my market short positions, lost some value due to declines in the precious metal miners I hold, and increased a short position in one particular company using a vertical option spread.

My portfolio’s performance for the YTD period ending on May 20, 2016, and the portfolio composition at that date is set forth below:

YTD Connolly portfolio gain as of May 20, 2016 equals +4.51%
S&P 500 Index YTD gain as of May 20, 2016 equals +0.41%
NASDAQ Index YTD loss as of May 20, 2016 equals -4.75%

Portfolio composition as of May 20, 2016 is as follows:

• Cash 50.8%
• Equities 32.9%
• Gold 14.7%
• Fixed Income 1.6%

Forecast for the coming week: There are many things weighing on the psyche of the market. Sentiment wants to take the market higher. The calendar with the Fed, Brexit and BOJ creates great uncertainty. Market leading investors are voicing concerns and expectations of a meaningful market decline. The movement of the US Dollar higher and the impact on commodities and emerging markets is of great concern. Yet market internals are not reflecting the voiced concerns, almost acting as if the market wants to catch the largest number of investors as is possible off-sides. Something has to give……….and there is a battle being waged.
My forecast for the week is more of the same meandering. I will not commit more capital to work until this market corrects down or real economic growth suddenly materializes. I will continue to hold my Gold investments to protect my net worth in these very uncertain times. I will look to go short quickly if we get any market dislocations, for the recent battering of the lower resistance points in the charts of the equity indexes could cause them to give way to dramatic moves lower. I am pessimistic, but forever hopeful that we will find a strong bottom that is followed by economic growth and a return to real productivity that benefits all.

Market Questions and Answers

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

After three weeks of declines in the DJIA, the DJT, the S&P 500 and the NASDAQ, this past week saw all but the DJIA bounce higher. The Relative Strength readings have all moved into the 60s, reflecting a weakening from the prior weeks. This is reflective of the recent point declines, and helps to clear away excesses of the past bounces higher. We are now moving to more of a neutral position in the RS readings.

Price Earnings multiples are north of 23.72X for the S&P and 18.71X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT bounced higher this week but remains in a declining chart pattern. It has been a leading indicator of the broader market, and with the rotational trading that has been taking place, a return to the selling of the transports would be a strong negative for the overall market.

The DJU had a meaningful correction down and reflects the expensive nature of the DJU given the prior investor preference for yield and safety being challenged by a potential rise in interest rates coming from the Federal Reserve. If it continues to move lower and there is an absence of confirming economic growth, this may be an area to once again invest in after its correction down has run its course.

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 11. 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 -11 reading indicates a mildly expensive market but is not reflective of a market that has come too far too fast.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 17.95X as compared to last week’s 17.76X. These are relatively high readings of price to cash flow when compared to the historic median of 16.91X. Of greater concern to me is the coupling of this high multiple based on current price and the 2016 year expected performance with the low growth rate over the following three years that is noted earlier in this letter. Subpar growth on a high multiple is not supportive of higher future prices.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 65 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 DCF price utilizing 2017 cash flow projections on the 187 Portfolio has narrowed and is now at $19.51, pulling back from the February high of $25.14. A higher spread indicates greater value to invest in whereas a lower spread indicates subpar returns will be realized from investing at current prices. The difference today is below the historic median of $22.51. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces potential gains.

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

The week’s volume and issues were aligned with the index point moves. Having said this, there was no directional indication that greater declines or increases are likely. This lack of a tidal buildup tells me the overall market is not expecting a strong move in either direction.

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 supportive of the market direction to the upside.

Where are the New Highs and Lows moving toward?

The New Highs and New Lows this past week in both the NYSE and the NASDAQ indicated a slight weakening in market action and a rotation between industry sectors. This is of concern as it feels like the child’s party game of trying to find a seat when the music stops, a “game” that has been embraced by the traders and will be in full swing until we get a dramatic move one way or the other. Remember, at some point the seats dwindle to the point where there is no place left to go.

How well are Market Tells correlating with Market trading internals?

Technically, the 5-day activity in volume and issues is supporting the change in prices but not with any degree of enthusiasm that strongly pushes sentiment 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 -5. Range is from +7 to -7. Contributors are:

Negative in the following areas:
Environment
Duration
Calendar
Valuation
Trend

Positive in the following areas:
None

Neutral in the following areas:
Action
Emotion

Other:

Bitcoin is at $441 per coin and is showing stable growth development. The per unit value based in the low $400 area over the past three months. Over the past year, the price has increased by roughly 100% 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.

Gold closed the week at the $1,252.9 per ounce, approximately $20 lower than the prior week. The metal has been range bound lately, and has failed to break through the $1,300 per ounce level. In the past week, the gold miners pulled back and my portfolio reflected the negative impact of that price decline. Given the continued global uncertainty and currency volatility issues that exist, I do not see material price weakness for gold in the foreseeable future and will therefore maintain my PM position to offset potential equity price declines from the broader market.

The Ten-year bond yield closed at 1.84% and has shown a great deal of volatility day-to-day. The prior trend did appear to be leaning toward lower rates but this past week’s release of the Fed minutes and the hawkish tone to raising interest rates had a meaningful impact on the term structure of rates within the United States. Of concern is a flattening of the yield curve (recession) and the absence of economic activity that a steeper yield curve would imply. We are above the weekly closing low for the calendar year that occurred on April 8 at 1.72%, and are 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. At some point this will likely weigh on the equity markets if the cost of US dollar financing rises.

Commodities: On April 29th the CRB index of commodities rose to its highest weekly closing level since July 2015. This past week, the CRB index weakened along with the strengthening of the US Dollar. This decline in prices hurts the Emerging Markets.

The High Yield vs Investment Grade spread appears to be trying to form a near-term bottom. We touched 4.255% on May 2nd and since then there has been a modest turn upwards. We closed this week at 4.314% and over the past three weeks the range has been very tight in terms of the spread. If this spread breaks out and moves upward this will be problematic for the equity markets as it will reflect greater market risk.

That about covers it for this week. I remain less aggressive and committed in terms of conviction than I like to be, but sometime you just have to play the hand you are dealt.

Watch carefully, and 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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