Listen to the Rhythm and Pulse of the Market

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning May 16, 2016
With Market Questions and Answers

Summary Comments:
Listen. It is one of the most important things we do and it must be done well to realize success.

This past week I went for a 5 mile run in Central Park. At the 3 mile mark my right calf muscle began to ache. I know this ache, for I have torn my calf muscles four times, three while running and once while skiing. I had a decision to make, press on to my goal with the risk that I would tear the muscle or stop my run. Tearing the muscle would take running away from me for anywhere from three to six months. I listened to my body. Stopping when I did served to keep me in the game. I just ran three miles today, Saturday, and it felt great.

Listen to your body, listen to the market, simply listen in life, and then, when digested and understood, respond in a way that protects you for the future while capitalizing on the opportunity of today.

As I listen to the market, I hear and feel an internal weakening, a need to reset, a need to create a value opportunity that is presently absent. The message from the market, its rhythm, its feel, echoes with the lyrics of Buffalo Springfield’s “For What it’s Worth”:

“There’s something happening here, what it is ain’t exactly clear….
…I think it’s time we stop, children, what’s that sound….”

For the past three weeks the market has been meandering, digesting a strong ten week upward move that countered an equally strong ten week downward move. This week, the market moved in a way that seemed to say, “Listen to me, take my pulse, feel and hear what I am telling you, and make a decision of whether to press on or to protect yourself.” This is what I listened to, and how I am acting in response:

• The revenue and earnings for the first calendar quarter of 2016 and the guidance for the future is weak. To be clear, the S&P 500 earnings forecast for 2016 that existed on January 1, 2016 was 6.63% higher than it is today, yet the market is basically the same price.
• On a weekly comparison basis, the NASDAQ index is meaningfully weaker than the DJIA and the S&P 500. On September 18, 2015 the NASDAQ peaked at a value that was 29.46% of the DJIA. Since then, the NASDAQ has declined consistently and on a relative basis today is at 26.90% of the DJIA.
Economic trends are uninspiring. Domestic Auto production, Durable Goods, Factory Shipments, Factory Operating rates, Industrial Production, Business Sales, and New Factory Orders are all below the prior year, and reflect a continued decline in growth since 2013.
Free Reserves in the US Banking system peaked in August 2014. Today they are $430 billion less as the FED has ended its QE program thereby withdrawing liquidity from the market.
• On a daily closing basis, this Friday the DJIA broke support that was important if we were to try and challenge the past highs in the market. The action in the market points to further weakness, and last week’s market commentary report “Aligning the Sun, the Moon and the Stars with Leadership” reflects the downward alignment that I see in the market. A 1,000 point DJIA decline would be consistent with the pattern and set-up of the market’s behavior.
• The Dow Jones Transports has broken support and is heading lower.
• The US Dollar that had been weakening after the G-20 Finance minister meeting in February found strength this week. If the US Dollar continues to strengthen the implications throughout the asset price chain is for lower prices.
• The 11 and 22 day averages of net volume have become strongly negative in a way that is very similar to patterns that have preceded large equity index declines in the past.

The market questions and answers that will be discussed below echo with the sounds of fatigue, of lackluster energy, of a tired market that wants to reset. Accordingly, I am more strongly positioned on the short side, coupled with cash ready and willing to be invested should the reset deliver value opportunities that are compelling.

During the past week I reshuffled parts of the portfolio, buying some beaten down names and increasing my short hedges. The Gold Miner equities sold off again this week but I held my positions as I see future strength given the uncertainty that exists in the market and the underweight of gold investing in most market portfolios. My portfolio’s performance for the YTD period and the resulting period-end portfolio asset allocation is set forth below.

The Connolly portfolio and the market performance for the Year-to-Date period ending on May 13, 2016 is as follows:

YTD Connolly portfolio gain as of May 13, 2016 equals +5.53%
S&P 500 Index YTD gain as of May 13, 2016 equals +0.13%
NASDAQ Index YTD loss as of May 13, 2016 equals -5.79%

Portfolio composition as of May 13, 2016 is as follows:
• Cash 50.5%
• Equities 33.1%
• Gold 14.9%
• Fixed Income 1.5%

Forecast for the week: I am currently positioned, and will likely expand that position, to profit from a market decline. This past week’s breaking of downward resistance on the daily charts has me focused on the weekly charts for confirmation of weakness in the coming week. A decline of 40+ points on the NASDAQ creates the momentum to contract market multiples with significant price drops. A 30+ point decline on the DJIA then brings a 300 point decline into play, and if that does not hold, there is a vacuum lower. An S&P 500 decline of 20+ points brings into play a 30 point decline, and if this does not hold, the decline will accelerate rapidly. There is material risk in the market today, and everyone should be very careful.

Market Questions and Answers

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

All of the indexes, other than the Utilities, are showing weakness to the downside. The NASDAQ is the most pronounced in pointing to continued declines. The consistency, whether in Relative Strength readings north of 70 for DJIA, S&P and NASDAQ that are weakening, earnings multiples north of 23.65X for the S&P and 18.77X for the DJIA, and chart patterns that reveal resistance to further moves to new highs, indicates meaningful risk exists to any investor who puts additional capital to work in equities.

The DJT has dropped under support and look as though greater declines are in store for this index. If it continues to break lower it could quickly drop by approximately 1,000 points.

The DJU had a meaningful correction down of approx. 5% in late April but has now reversed and is back close to new highs. It continues to reflect the safety of yield in a nervous world of Central Bank easing and Negative interest rates on foreign government debt.

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 an only mildly expensive market. If we get the market declines that the other indicators are forecasting, we should see real value opportunities begin to emerge on the Market Tells metric.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 17.76X as compared to last week’s 17.93X. These are relatively high readings of price to cash flow when compared to the historic median of 16.8X.

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 $20.31, 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 $22.53. 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 decline. Having said this, there was no directional indication that greater declines or a reversal to the upside are likely. This lack of a tidal buildup tells me the overall market is not expecting a strong move in either direction, which I believe is wrong and if the momentum starts to swing it could result in large moves as the crowd moves to one side or the other.

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.

Where are the New Highs and Lows moving toward?

There is divergence in terms of degree between the New York Stock Exchange and the NASDAQ. The companies traded on the NYSE are exhibiting an expansion of both New Highs and New Lows. The companies on the NASDAQ are showing fewer New Highs and an expanding number of New Lows over the past three weeks. Combined as a market measure, this is a net negative.

How well are Market Tells correlating with Market trading internals?

Technically, the 5-day activity in volume and issues is supporting falling prices but not with any degree of enthusiasm that strongly pushes sentiment one way or the other. The fundamentals of the Market are indicating a somewhat expensive story. A breakout to the downside feels as though it is pulsing beneath the surface given the overall combination of technical and fundamental indicators.

What is the composite reading of the Calendar, Environment, Duration, Action, Trend, Emotion and Valuation Index (“CEDATEV”)?
The reading is -6. Range is from +7 to -7. Contributors are:

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

Positive in the following areas:
None

Neutral in the following areas:
Calendar

Other:

Bitcoin is at $455 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”) given the success and reach of its digital online payment platform and, in the mobile space, its penetration of the Millennial generation with the Venmo App platform for mobile devices.

Gold closed the week at the $1,274.30 per ounce. Continued currency weakness and Central Bank actions to keep interest rates at low or at negative levels is supporting the price of Gold. Additionally, China continues to purchase meaningful quantities of Gold and just launched a Gold trading vehicle priced in their local currency vs US dollars. The price action and the demand for equities of Gold and Silver mining companies has been very strong this year. Many of these companies have more than doubled in price.

The Ten-year bond yield closed at 1.70% and has shown a great deal of volatility day-to-day. The trend does appear to be leaning toward lower rates. We are below the weekly closing low for the calendar year that occurred on April 8 at 1.72%, and is well 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 is firm. This rise in prices helps the Emerging Markets navigate the economic challenges of being resource providers to the world markets. With higher raw material prices in the world markets they can sell their natural resources at better prices and thereby support the social and economic needs of their countries at a more comfortable level. As a precautionary note, I should point out that any strength in the dollar and associated rise in US interest rates will likely cap any future price increases here.

The High Yield vs Investment Grade spread has found a near-term bottom it appears. We touched 4.255% on May 2nd and since then there has been a turn upwards. We closed this week at 4.457%. If this spread continues to move upward this will be problematic for the equity markets as it will reflect greater market risk is being priced into the overall financial markets.

That about covers it for this week. I believe we are in the midst of a transition to lower prices in the equity market.

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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