This month we cover the following topics:
Developed economies across the globe are exhibiting growth, but the US growth is decelerating.
What are stock market valuations telling us?
Are we peaking or setting up for a continued increase in equity prices?
Digital currencies, fever or reality?
Where in this market am I allocating capital?
The Imagining the Future section focuses on China and the One Belt One Road initiative.
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The May Newsletter on the U.S. Economy and the attractiveness of Investment choices from Connolly Financial Advisors is due to be released to subscribers on May 20, 2017. The April newsletter that discusses the attractiveness of investing in India, Bitcoin, currency positions in the Foreign Exchange markets, long and short positions in commodities such as Cocoa, Oil and Precious metals, and a select group of long and short equity candidates for future investment, was distributed to subscribers on April 23rd, and is attached below for your enjoyment. I should also note that subscribers to the newsletter receive trading alerts during each month on the day of the trade when I buy or sell any investment asset.
Should you wish to subscribe to the upcoming May newsletter, please drop me a note here or email me at firstname.lastname@example.org
A key statement from this month’s Executive Summary is: “As we wade through the Economic, Fundamental, Technical and Tonal aspects of the markets in this month’s essay, all of which confirm the current state of Market Churn and possible topping action, there is a gem hidden within these writings, one that should be pursued in terms of seeking knowledge.”
The April 2017 newsletter has just been issued and covers the following areas:
- Economies across the globe are exhibiting growth.
- What are stock market valuations telling us?
- Why are we churning each day in a way that leaves us running in place?
- Are we going through a topping pattern?
- Where am I allocating capital in this environment?
- The “Imagining the Future” section looks into what may be one of the most compelling investment opportunities in the world today
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The Newsletter for March is now free and is available below by clicking on the link to the article.
|Executive Summary Issued March 17, 2017|
|Economic growth, inflation and interest rates are on the rise across the globe. Fiscal stimulus is beginning to complement/replace monetary stimulus and the impact is giving us economic green shoots, optimism, expanding employment, increases in production and consumption, and the emergence of rising inflation expectations. These factors, along with a pro-business posture in government, have directed the strong monetary flows that have been in the financial system and channeled them with aggressiveness into the equity markets. The result has been a dramatic rise in the equity indexes since November 2016. This rise has been further fueled by the movement of the retail investor out of money markets and into equity index funds. The monetary fuel and the expectations of a struck fiscal matchstick have ignited this fire, and for many it has been a great ride. For others, there is a sense of having missed the parade which is driving a newly inspired desire to join in and to buy stocks. Per the WSJ, Fund tracker EPFR Global reported record net inflows into equity mutual and Exchange Traded Funds during the week of March 1st, clear evidence of the herd moving in one direction. Jamie Diamond of JP Morgan was recently reported to have stated that the animal spirits are back and in play. I wonder if that is good or bad.
A contrary observation to the above is the ratio of company executives buying shares to those selling shares in their own companies. This ratio has slumped to a 29-year low as selling overwhelms buying. That observation more or less aligns with my personal activity in the market. I am not joining the buying parade, for while the reasons for the powerful move higher have substance, the regime of the market in terms of over-valuation, weakening market internals, and the move towards tightening of monetary policy present a real reason to be cautious and conservative until a better entry point appears. That summarizes my current approach.
The link below will provide you with the full report.
What investing regime are we now in?
We are transitioning away from the Central Bank stimulation regime.
What may be the new Regime? An environment of fiscal stimulus in China, Japan and the United States. A spending of money by governments to stimulate growth, a global reflation environment.
This is what has driven the equity markets to new highs. My sense at this point, given the anticipatory move higher in equity prices that has already occurred, is that it is too late to buy and too early to short.
The phase we are in is an early inflation set-up, one that will continue to expand and that will have meaningful impact on various asset classes. What to do? Buy Gold and Silver. With inflation emerging, real interest rates will become negative and that will drive interest rates higher. Short bonds and buy TIPS. Inflation should help commodity countries, so emerging market ETFs and commodity ETFs become more attractive. Finally, with paper currencies walking around with a target on their back as governments try to increase tax revenues by attacking the black market and the shadow economy, it may be prudent to establish a small position in Bitcoin.
Witnessing the recent and continuing equity market climb to new heights reminds me more and more of the years of 1999 and 2000. For me, those years were consumed by an aggressive buying of equities as I increased my initial capital in the market from a base of $250,000 to $11,500,000, entirely through price increases. I thought it would never end and that I had become the invincible winner of selecting companies that would grow forevermore. What I did not appreciate at that time was my ignorance of what a bear market felt like and what it could, and in my case would, do to my outsized gains. It was a very meaningful education.
Today, I believe that education is being called upon. Prudence is my mantra and it governs how I begin each and every day. I do not feel this is the time to buy, the time to get on the bandwagon for a ride to glory. It feels more like the time to reap the rewards that have emerged and to watch the parade from the sidewalk for awhile. It is an interesting view.
Thoughts are blossoming in my mind about a connection between prior outcomes and likely future outcomes that find similarities between the housing market boom/excess, the central bank QE efforts to add liquidity and boost prices, and the emerging global initiatives by governments to take on additional debt for military and infrastructure projects. History seems to indicate that there is an existing and growing level of risk in the system that is not reflected in the financial markets.
During the 2004 thru 2008 timeframe, securitization of debt obligations emerged in a way that was marketed to investors as containing minimized risk in obtaining outsized returns. This fed liquidity and encouraged investment bank demand for greater supply to meet investor desires for higher returns with low levels of default risk. The supply was provided by new mortgages to finance an ever-increasing amount of housing demand that was being driven by free/low cost financing of homes. Many of the new buyers had insufficient incomes to purchase a home, but the need for more mortgages to meet investor demand for securitized mortgage packages caused the banks to lower the income requirements thereby bringing greater levels of buyers into the market. The new buyers’ income levels could not support the home price without ever increasing access to debt to fill the gap of price to income. The growth in mortgages fed the debt securitization machine, and was further exacerbated by the selling of “insurance” on debt defaults to buyers who had no risk of principal on the debt being insured. All of this low-cost financing that mispriced risk ultimately turned out very badly for the world.
The parallel that appears to be taking place today scares me in that if it continues to expand in an unchecked manner we will find we have a larger problem then we had in 2008.
Central banks across the world have used monetary easing policies to avoid debt defaults and economic contraction. These policies have resulted in the Central Banks becoming the buyers of the debt issued by the governments of the world. Market pricing of risk is absent as there is in the market a committed buyer at any price with unlimited access to money through the ability to print paper currency (actually, digital currencies), and to use this printing to buy all of the debt the market chooses to not buy, holding interest rates down in short term maturities and creating demand in the market for longer term maturities at depressed rates. The duration of debt, the life of the debt, being held by market participants at historically low rates of interest create price/principal risk to the owners that could be crushing if global interest rates rise. Think about this in terms of the similarity in the explosion in U.S. mortgage debt outstanding in the mid 2000’s and the explosion in U.S. government debt post-2008. In the United States, government debt over the past eight years has grown by approx. $10 trillion (a doubling of debt from 2008) similar to the U.S. Residential Mortgage debt that doubled between 2001 and 2007. Add in the rest of the world’s issuance of ever increasing levels of government debt and we are awash in liabilities that are at a level that has never existed before, and this debt is being priced at low interest rates as if no or little risk exists, just like the housing market priced mortgages.
The post 2008 debt growth increased asset prices in stocks, bonds, and in many physical assets. This is similar to the way in which housing prices rose in the mid 2000’s based on the low cost to finance and easy access to excess credit availability. The current increase in asset prices has not occurred in an environment where incomes are expanding. In effect, the debt purchases by the Central Banks are filling the void that income cannot fill in supporting price increases. At some point, the level of debt will reach a critical and limiting point of excess unless incomes and GDP growth expand rapidly to justify the asset prices we have today. The answer to the question of where that income expansion is going to come from is paramount to the avoidance of a price correction lower. Absent a rational answer that indicates favorable odds exist of realizing sufficient income growth that will rebalance the fundamental relationship of earnings to price, there exists a much higher risk in buying assets at current prices than the market is anticipating.
The outlook for future debt expansion after an incredible growth in debt over the past decade is troublesome. The only way the US can finance the level of infrastructure investment and military expansion that is being contemplated is to take on an ever-increasing level of debt. The hope or plan is that by deficit spending we will drive economic expansion and income growth. However, our starting point of existing debt is problematic to the efficacy of filling the current income price void with more debt in the hope of accelerating future income growth. We are entering the Catch-22 phase and that is scary (need more debt to generate more income, with new income being consumed by the interest cost of the new and old debt vs new income enabling new investment to drive additional new income sources).
During the past eight years, we have increased annual Government transfer payment to the population of the US by $800 billion per year (now over $2 trillion annually), which has cumulatively added to our national debt during this period by an incremental $2.9 trillion. That increase to our debt served to provide financial support to people in need versus investment in productive assets (no political point of view on this, just simply stating facts). Going forward the $2 trillion in annual transfer payments will continue to add to our debt before any impact of additional deficit financing for new investments. The continued growth in the gap of our spending to income is troublesome, and the more debt incurred without an acceleration of income poses higher systemic risk to our economy and a meaningful potential decline in the value of the dollar.
The risk to the value of the U.S. dollar is simply a story of supply and demand. The additional supply of currency coming to the market that will be created by financing our existing obligations such as interest payments and transfer payments, plus the new infrastructure and military investments, will debase the U.S. dollar’s value in terms of purchasing power given the lack of income driven investment growth by the private sector that is needed to serve as an incremental demand factor for dollars. This will ultimately stall the power of the economy and lead to stagflation and levels of government debt that are not serviceable from tax receipts given the lack of income growth.
We and the world have a problem, and the lack of global growth coupled with deficit financing and Central Bank buying of governmental debt will one day reach a point where default is the only available path. It will be a very bumpy ride when we get there, and being prudent with investment decisions will one day be rewarded.
The letter in its totality attempts to present for myself and for anyone with the patience and inclination to read it, enough information so that there is comfort in the direction of the mid-term investment horizon, regardless of short term swings. The information that follows presents:
• A technical look at the underpinnings of the equity market
• A fundamental look at the valuation of the market and its capacity to expand
• An economic look of the United States given the dependence of future profits on the growth of the overall economy
The summary views of the above three areas reflect a high level of caution as the technical data is weakening and momentum is peaking, the fundamental data is at extreme levels of high valuation, and the economic data is showing signs of growth that, while positive, do not broadly reflect a rapidly expanding economic base. With this collection of information now pooled together, it is my conclusion that the risk of a meaningful decline in the equity markets is more likely than a continued rise. As my many prior postings have revealed, I have been cautious over the past six months, and the assessment I am making now is one that has moved from caution to an outright expectation that there will be a large fall in the equity indexes.
I wish for everyone abundant returns and profits in the upcoming year, and while I have a rather doleful outlook on the potential returns from equities at the present prices, it is with hope that I look to the future making what I believe are prudent and wise decisions in all aspects of life.
1. DJIA 3% Data: I measure the magnitude and duration of changes in the DJIA when there is at least a 3% change in the index. Currently the DJIA is in an uptrend period. The current movement since the last 3% decline shows a positive Return of 10.90% as compared to the historic average of 9.0%. The time period over which this 10.90% increase has occurred is 7 weeks as compared to the historic 8.8 week average for up periods. This indicates we may be in the late stage of a rally, as this move came off of a 3.73% decline with a duration of 11 weeks, so the up-market was not recovering from a deeply oversold condition that might support a much higher up period beyond the historic average.
2. OTC 3% Data: Currently in an uptrend period. Return is 8.13% vs historic average of 12.50%. Time covered is 7 weeks vs 10.6 week average for up periods. Indicates we may have more to rally. The move higher follows a 5.07% decline (below historic decline average of 9.3%) that took 5 weeks (equal to historic avg). Similar to the DJIA, the market was not rebounding off of a deep oversold condition, so this move higher may run out of gas over the near term.
3. Weekly Relative Strength variances from the Mean indicate an overbought condition:
a. Over the next six weeks, absent new point gains or losses of a material nature, the RS indicators will not move in any notable way. The net weekly up and down changes that will roll off net to zero, with no individual week containing greater than 140 DJIA points.
b. DJIA: We are at extreme levels in the twelve-week RS Up measure and in the RS Sum measure. Both are more than 1 Standard Deviation from the historic mean and absent a meaningful move down, the RS will not change materially.
i. The RS Up indicator resides at 2,076. Levels above 2,000 have occurred 51 times since 2007, a 10% occurrence rate. One Standard Deviation indicating an overbought condition occurs at the 1,818 level. At this time, we are 1.56 SDs away from the mean.
ii. The RS Sum indicator resides at 1,633. Levels above 1,600 have only occurred six (6) times since 2007, a 1% occurrence rate. One Standard Deviation indicating an overbought condition occurs at the 999 level. We are presently 1.88 SDs away from the mean. For the six times in the past ten years where we have been this extended to the upside, within approximately four weeks, five of those periods experienced declines in the 400 to 500 DJIA point area.
iii. The 12 week RS Down indicator currently resides at -443. This is one SD away from the mean and further indicates a condition that is unbalanced given the lack of normal swings in weekly market activity. History has indicated that declines after reaching levels near the -440 area range between 500 and +1,000 negative points over the ensuing 12 weeks.
c. NASDAQ: This index is not as overbought as the DJIA. The RS Sum and Down indicators are mildly overbought, and do not indicate extreme levels at this date. The RS Up indicator does reflect an extreme condition that is 1.72 Standard Deviations away from the Up mean, and is by itself a cautionary indication. There is no appreciable impact over the next six weeks from the rolling off of prior periods, so the current condition will not change absent appreciable point moves in the coming weeks.
4. Relative Strength Oscillators that measure turning points in the market indicate the following:
a. For the DJIA, given its relative stability vs the NASDAQ in terms of volatility, a comparison of the 4-week average and 12 week average volatility has proven to be a quality metric in predicting market turning points.
i. Presently, the RS down measure equals a value of 20 within the defined range of 0 to 100. A measure between 0 and 20 indicates an extreme overbought condition. A measure between 80 and 100 indicates an extreme oversold condition.
ii. The RS Up measure equals a value of 97 within the defined range of 1 to 100. This level strongly indicates an index decline is relatively close in time.
b. For the NASDAQ, the greater volatility requires a longer measurement period to generate a more reliable indicator. Here we utilize a comparison of 4 week changes against 16 week changes in the NASDAQ Relative strength index. The activity and high volatility that has taken place over the past five weeks has placed both the RS Up and RS Down measures at or close to turning points. The RS Down measure is 96 and the RS Up measure is at 75. The only trend change we see is the beginning of a turn to the downside for the RS Down measure, and a continued acceleration to the upside for the RS Up measure. This indicator implies that more time will be needed before a reliable turning point arrives.
5. Daily Factors that contribute to the timing decision of the market continuing or changing its direction, include the following:
a. Daily Volume: The comparison of magnitude of the market point changes to the changes in market share volume often highlight internal support or lack of support for the movement in share prices. Presently, the Volume measure has been exhibiting a declining level of positive volume given the point increase in the stock indexes. Over the last 26 days the DJIA has increased by 2,000 points while the volume point relationship has declined from .90 volume per point to .85 volume per point over the 26 day period of the current market rally. This indicates a weak level of support for the index move higher.
b. Daily Issues: Consistent with the discussion above, and even more pronounced is the relationship of issues advancing versus index point changes. Here the relationship over the same 26-day period has moved from 3.02 to 2.59 which indicates a declining level of participation by the broader market in the index advance. Every time over the past three years, when this indicator has reached the 2.65 level or lower the market has reversed from a high point, typically experiencing DJIA declines of 500 to 2,000 points over the next 20 to 30 days post reaching the 2.65 level.
c. Volume and Issues in a combined comparison for advancing components and separately for declining components indicate a lower level of support behind the index advance. The advancing components are rising but have not attained levels that would be consistent with the magnitude of the index increase. The declining components are falling, but similar to the advancing observation, they have not fallen to levels that would historically be present in an advance of the magnitude we have experiences over the past 26 days.
The above factors do not provide a sense of immediate urgency in regard to a reversal being imminent. That is not to say that the market will not fall in the near-term (month of December), it very well may decline precipitously, however it does indicate that the advance is not well supported, which raises the risk of a material decline within the next eight weeks, if not sooner.
6. S&P 500, DJIA, DJT, and NASDAQ Momentum Oscillators: Each of these oscillators have been tested against historical data resulting in 24-week measurement periods for each that are based on the best fit of indicator reading to subsequent performance of the index. They are all at or are approaching peak levels that have historically marked the end of a short-term trend move. The oscillator range is 0 to 100. Reaching peak levels of 80 or higher have consistently indicated the end of an up-move. The S&P 500 reading is 91. The DJIA reading is 80. The NASDAQ reading is 89. The DJT reading is 87. I am not a buyer of equities at these levels and my recent actions this week (Monday December 12, 2016) reflected selling of shares in companies I hope to buy back at lower levels in the future. Following the adage of buying low and selling high governs this action.
7. Five-day summation of the DJIA point change compared to the NYSE net change in volume and issues for the week indicate a weakening state. For the prior five days, the DJIA has risen by over 600 points. The corresponding period net advancing volume over declining volume is 565 billion shares. The corresponding period net advancing issues over declining issues is 599 issues. Contrast this present state with the historic averages dating back to October 2009, and we find that there is a lack of underlying support for the index point advance. Historically, the average 5-day advance in points is 198 points, corresponding to average net advancing volume of 807 billion shares and net advancing issues of 2,372 companies. The lack of underlying participation in this index rally is very troubling in the non-confirmation of staying power.
8. Net Annual Advancing Volume as a percentage of total NYSE volume of shares traded is meaningfully above the historic average. Dating back to 2009, and utilizing a year period commencing on October 1 to focus on the seasonality of the fourth calendar quarter as reflective of the most up-to-date earning predictions for the current year and following year, this assessment looks at the relationship of the total net volume of advancing/declining shares traded to the overall volume for the year. On average, the annual net advancing volume over declining volume has measured 2.7% of total annual volume. The range for each year is as follows: 2009/10 = .4% (with a corresponding DJIA rise of 1,238 points); 2010/11 = .5% (with a corresponding DJIA rise of 135 points); 2011/12 = 4.4% (with a corresponding DJIA rise of 2,799 points); 2012/13 = 2.8% (with a corresponding DJIA rise of 1,769 points); 2013/14 = 3.3% (with a corresponding DJIA rise of 1,760 points); 2014/15 = -2.1% (with a corresponding DJIA point decline of 733 points); 2015/16 = 3.2% (with a corresponding DJIA point rise of 1,974 points). For the Y-T-D period from October 1, 2016 thru December 13, 2016 mkt open the percentage is 4.7%. (with a corresponding 1,563 point rise in the DJIA index). Clearly, the relationship that currently exists reflects a robust full year set of positive results, yet we are only a little over two months into the year. A correction will likely come soon to bring into balance the current year with the historic balances, as we presently reflect a full years relationship that is not viewed as being capable of moving much higher given the underlying fundamental market valuations that presently exist.
The technical picture is one of extremes or approaching extremes that indicate a market reversal/decline is highly likely in order to bring about a more balanced pace of change, a pace of change that is more in line with the historic patterns of the way in which the stock market typically behaves. Extreme states are exceptions, not the norm, and these occurrences resolve themselves through corrections, for as the saying goes, “nothing grows to the sky”, and this current market advance has surely tried to do just that.
The next question is one of magnitude. If we are at extreme levels of technical market behavior that point to a need for a price correction lower, then how large will that correction potentially be? The answer is most likely found within the comparison of current stock valuations vs what may be considered normal market valuations. For this, the assessment is based on the historic relationships of fundamental market factors such as earnings, cash flows, debt levels, interest rates, dividend levels, and overall market return metrics that encourage or discourage further changes in stock prices. The fundamental data that follows indicate we are at an extreme level of valuation indicating the magnitude of the correction when it comes will have the potential to be dramatic in size. Consider the following:
1. Price of equities compared to the cash flow they generate: The historic relationship of stock prices to cash flow produced, which is simply dividing the stock price by the per share cash flow a company earns, averages 17.2 times based on the current cash flow performance, and assuming growth in cash flow in the following year, averages 15.2 times on what the company is projected to generate in cash flow for the following year. Given the rise in stock prices, it would be expected that the growth in cash flow supports the price change thereby maintaining the historic relationship of price to cash flow. Based on the 2016 cash flow results and the 2017 cash flow forecast for stocks, the current price to cash flow relationship now resides at a price to cash flow of 22.29 times for 2016 and 19.59 times for 2017. Clearly we have stock prices that are priced at a premium to the cash they generate. What is the degree of this premium pricing in the current market? It is the highest premium since 2007, in fact it is higher than 2007, and would require an approximate 25% stock price decline to bring the price to cash flow relationship back in line with history.
2. Given the importance of growth in cash flow and earnings to stock prices, what do analysts currently project for cash flow and earnings in this year and for next year? For cash flow, the growth rate for 2017 is 14.03% higher than projected 2016 cash flows. For 2016, the cash flows are actually lower than 2015 by minus 1.95%, so the forecast for 2017 is coming off of a negative growth year (BTW, in December 2015 the cash flow growth projection for 2016 was 12.53%, and that turned into actual negative 1.95% growth). Given the double digit rise in the major stock market indices in the United States for 2016, clearly the poor 2016 cash flow results are not what is driving stock prices. It must be that the projected growth for 2017 far surpasses prior expectations. As noted above, that growth is projected at 14.03%. That growth rate is slightly above the historic projections of growth one year out that has averaged 12.9% over time. Yet even with that above-trend growth rate, stock prices are values at 19.59 times forward cash flow, a very high premium. What about earnings on the S&P 500? For 2016, earnings look like they will only be .6% above 2015, so this has not been a very good year for earnings either. The difficulties in the oil market were a serious depressant on 2016 earnings. What about the forecast for 2017? Currently that forecast is for 12.25% growth over 2016. Healthy, but again not enough when we see this earning growth translated into a price to earnings ratio. If we assume no further appreciation in stock prices, then based on projected 2017 earnings, stocks are priced at 19.35 times. That is a very rich multiple based on history.
Speaking of history, what do we see in terms of projections made and results obtained? In the case of cash flows, the projections have been much higher than the actual results obtained. Since 2009, the actual cash flow generated was 6% below the projection. In fact, for the seven-year span from 2009 through 2016, the actual results have been below the projections in five of those years, and those shortfalls have averaged 9.5% below the projections. Given the track record and the robust 14% cash flow growth projected for 2017, it is hard to see the current stock price environment as reflecting a buying opportunity.
3. Staying on the cash flow theme for one additional point, it is important when valuing companies to look to the cash they generate. Cash flow and cash flow growth over time are critical in assessing investment opportunities; After all, the purchase price of a stock is based on the buyer’s decision to buy an asset with the expectation that the cash the company generates will enable the company to return to the purchaser sufficient cash and/or appreciated business opportunities through re-investing cash to justify the current price paid for an ownership interest. As such, the value of a share today is directly linked to the future cash it will generate. The discounted cash flow model incorporates the expected future cash flows, the growth in those cash flows, and a discount factor to adjust the cumulative value of the future cash for the risks inherent in the uncertainty of tomorrow and for the years (time) it will take to produce the cash. One of the measurements of a given portfolio of stocks is to assess the composition of the portfolio by determining the number of the companies represented within the portfolio that are presently priced below, at or above their discounted future cash flows. Utilizing a pre-existing portfolio of 187 companies as a barometer of the overall market, the historic average of the number of companies that are priced above their DCF computed value lies within the 60 to 61 range. So, at any point in time one can expect that roughly a third of the portfolio is over-valued, while two thirds are fairly-valued or under-valued. This assessment enables buying and selling decisions to be made with the goal always of buying low and selling high. The question today in order to assess whether we are in a normal market or a market that is priced away from the norm is “How much of the portfolio, given current prices and projections of future cash flows, is valued above the historic one third of the portfolio?” The answer is troubling for it indicates we are at extremes that have not existed in the ten years that this portfolio of 187 companies has been tracked. As of Friday, December 9, 2016, 53.5% of the companies tracked are priced above their Discounted Cash Flow price. That level has never been reached (over the past ten years). Further, as a combined portfolio, how does the price of the overall portfolio compare to the overall DCF price? The DCF price of the portfolio is currently $5.99 BELOW the current aggregated price of the portfolio. Historically, the DCF price has, on average, been higher than the current price by $11.29. This indicates a gap of $17.28 ($5.99 plus $11.29) exists, a gap that is larger than any difference seen over the past ten years. To bring the relationship back to normal, current prices would have to decline by 21%, or cash flow would have to increase by 19% above the current projection for 2016 and the cash flow growth rate for future years that was previously projected at 14.03% would have to increase by 20%. The risk in realizing these growth rate improvements is high, and the more likely outcome will be a deep overall market correction to bring values back into balance with realistic company cash flow and earnings growth prospects.
4. Two final points on cash flow need to be included as part of the discussion. The first is a comparison of each year between 2007 and 2015 against 2016. This analysis compares the change in price and the change in cash flow for each year against the current year’s data. For example, there is an expectation that the changes will be correlated such that increases in price will be directly connected to increases in cash flow. This exercise yields results that fit the expectation of a high degree of correlation between the two sets of data. At least it did through December 2015. At year-end 2015, the change in price from 2007 thru 2015 was an increase of 56.98% while cash flow increased by 65.31%. If we also look at 2009 vs 2015, we see a price increase of 80.63% and a cash flow increase of 88.53%. With that as the backdrop, how do the comparisons look when we replace the 2015 data with 2016 data? Here we see the breaking down of the correlation. The comparison of 2007 to 2016 shows a price increase of 81.88%, but only a 62.09% increase in cash flow. For 2009 vs 2016 we see a price increase of 109.29%, but only an 84.86% increase in cash flow. Price expansion is outstripping the growth in operating performance and that would appear to be problematic for sustaining the price increase. While there is an expected growth in cash flow for future periods, the growth estimates would need to be materially higher to bring the long-term price and cash flow change relationship back to their historic correlation. Absent this, the sustainability of the current price increase and the potential for additional price increases in equities is doubtful.
The second point is one of comparing the average compound annual growth rate of price and cash flow. The reason for including this is to assess the impact of the current year’s changes in price and cash flow in the context of history. The expectation is that there should not be a material divergence from year to year in trajectory of these two measures. The average CAGR in price and cash flow for the combined periods 2007 thru 2016, 2008 thru 2016, 2009 thru 2016, up to and including 2014 through 2016, when contrasted with the same calculation that also includes the additional period of 2015 through 2016, reveals a troubling divergence that is not likely to remain unresolved. Through 2014 there is an average CAGR in price of 12.0% and in cash flow of 5.2%. When 2015 through 2016 results are added, the average price CAGR rises to 12.4% but the average cash flow CAGR falls to 4.4%. It is hard to accept that this observation which is being driven by the rise in equity prices in 2016 without a corresponding increase in cash flow is not a warning of a market that is being valued above what a rational buyer should pay for the risk that is inherent in achieving an adequate return on invested capital.
5. Balance sheets matter but do not get enough focus in the media as compared to earnings and stock prices. When balance sheets are combined with the earning and price discussion there is often found very important indicators. One of those indicators is the relationship of earnings before deductions for interest costs, taxes and non-cash charges such as depreciation (”EBITDA”), to the overall Enterprise Value (“EV”). EV/EBITDA is a capacity measurement that is computed by dividing the Enterprise Value (“EV”) of a company (its current stock price multiplied by the number of shares outstanding plus the level of debt the company has on its balance sheet, less the amount of cash the company has that offsets the debt owed), divided by the cash flow power of the company as measured by EBITDA. This calculation creates a view of how well the company can support its net debt burden from cash flows, and gives a relative measure of each company’s degree of access to greater capital needed for growth. A low EV/EBITDA number indicates financial strength as the cash flow is high relative to the level of net debt and the current stock price. A high EV/EBITDA is a cause for caution and should be a trigger for greater analysis of the company and the industry characteristics in which it operates. Creating an historic perspective of this indicator over time as prices change, debt and cash levels change, and business prospects change, provides a key element of overall market valuation levels, particularly when combined with the other observations that have been previously discussed elsewhere in this document. With this as a backdrop, what does the EV/EBITDA metric indicate in today’s market? Of concern is the fact that this metric is at its highest level in the past ten years. The EV/EBITDA ratio is 15.03. To provide some comparative data, consider that the low was set in November 2008 after the Lehman bankruptcy filing when the market value decline caused the ratio to fall to 6.64. Over the past ten years prior to 2016, the average high and low ratio was 12.31 and 9.21, respectively. The current level of 15.03X is a cause of concern, but the driver of this needs to be better understood. If balance sheets are relatively stable in terms of the cash to debt levels, and the high multiple of the EV/EBITDA is driven by a decline in earnings, then the determinant of level of concern would be prospects for higher operating performance in the future to support the market value component of EV. If, however, the debt and cash levels have changed in a way where the companies reveal high EV/EBITDA multiples because debt meaningfully exceeds cash in a way that poses risks to the funding of future growth, then a concern for the high market value of the stocks must be taken into account in assessing prospects for future price increases and the potential risk of a material price decline. This is where a meaningful problem or issue exists in the 2016 analysis. Debt has grown since 2013 by 39% while cash on the balance sheet has only grown by 13% (for the 187 company portfolio, debt has increased in dollar terms by $475 billion whereas cash balances have only increased by $105 billion). Further, cash flow growth over this period has grown by only 16% while prices have risen by 31.5%. So, the balance sheet deterioration in terms of higher leverage and the slowing in earning/cash flow growth are real problems in the current market state. Couple this with the lack of robust projected growth in earnings and cash flow at a time when the balance sheet starting point is weakened creates a very high concern for maintaining the current level of stock prices in the market.
6. The balance sheet discussion and capacity to source additional capital for growth also offers the opportunity to talk to the cost of financing and what if anything we may learn from looking at changes in the cost of capital. The Weighted Average Cost of Capital (“WACC”) is currently at the lowest level in the past ten years. The key driver of the decline in the WACC is the equity component. WACC is a blend of the cost of debt (interest rates) and the cost of issuing shares (required return sought by investors to own shares of stock) weighted based on the proportion of debt to equity levels. Interest rates have been very low since the financial crisis of 2008, so the past eight years have encouraged debt growth as a low-cost source of capital. With the recent rise in interest rates, that low cost source of capital may begin to become more limited. The cost of equity is very much influenced by the perceived risk that investors in equities believe is inherent in owning stock. This equity risk is a price risk as well as a return on investment risk in the form of dividends and dividend growth prospects. When the market is relatively calm, upward trending, and backstopped in the minds of investors by external influencers such as the Federal Reserve or other governmental bodies, then the appetite of investors to pursue equities is large and their demand for high compensation is lowered as they perceive less risk exists. It is in these calm or perceived calm waters that we see aggressive buying of stock with an almost risk-free attitude. Given the world in which we make investment decisions, and the manner in which that world is changing, the question of whether we have more, less or the same uncertainties to consider must be addressed. Presently, the equity component of the WACC has a cost that is below 10%. This is a very low rate of required return. In fact, history would indicate that a rate of 13% or more is a better reflection of the historical cost needed to compensate equity holders for the uncertainty in holding equity vs debt. Given the political and global economic risks that exist in the world today, it must be asked whether the current equity market pricing and demands by investors are reflecting complacency and in doing so are ignoring/mispricing the realities of the risks present in the world? This is a subjective question to some extent, and investor fear or decisions to de-risk often are quick to change in a world where events occur with little forewarning. Pricing the cost of equity capital at a level below 10% in a rising interest rate environment and in the face of a new governmental leader for the United States, coupled with BREXIT, movement in the price of oil, European concerns, and actions by China and Russia, all of which add to uncertainty that arguably is NOT being reflected in the pricing of the equity market should give one reason to pause. Given the speed with which equity investors may pull back from the market should uncertainty be felt as increasing, it may require great caution and vigilance to ensure return of capital is seen as the more important goal then return on capital in the present market place.
The United States economic indicators have been negative for so long, but in the last quarter of 2016 we see the long awaited change to positive readings. It is encouraging. The positive economic measures are accompanied by positive changes in money and interest rate indicators, with offsets from negative readings in equity market and foreign exchange. So we have a bit of a mixed bag, but do see the blended economic picture as more positive then it has been over the past years.
The economic indicator is a composite of the following factors:
• Durable Goods produced and Durable Goods Orders
• Factory operating rates, inventories, shipments and new orders
• Business Inventories and Business Sales
• Domestic Auto Sales
• Construction Spending and New Building Contracts
• New Housing Starts
• Personal Income and consumption
• Consumer spending
• Average New Home prices
• Baltic Dry Rates
• Steel Production
• Electric Power Usage
• Exports and Imports
• Jobless Claims and Continuing Claims for Unemployment
• Mining and Petroleum Rigs running
• Producer Price Index
Money and Interest Rate indicators are a composite of the following factors:
• Total Loans outstanding in the U.S.
• The M2 Money Supply
• Free Reserves in the U.S. Banking System
• The Federal Funds Rate
• The rate spread between Investment Grade Corporate bonds and Intermediate Grade bonds
• The rate spread between the Ten-Year Treasury bond and Intermediate grade Bonds
• The 3-month Treasury Bill
• The ten year Treasury Bond
The Market indicator is a composite of the following factors:
• The Price Earning ratio of equities
• The yield gap between fixed income coupon payments and dividends paid on common stocks
The Foreign Exchange indicator is a composite of the following factors:
• The UK Pound, China Renminbi, Japanese Yen, and EURO vs the U.S. Dollar
The individual indicator readings of the four categories currently read as follows:
• Economic reading of positive 174
• Money reading of positive 190
• Interest Rate reading of positive 46
• Market reading of negative 260
• Foreign Exchange reading of negative 115
Below is the chart of the year-over-year percentage change in the individual economic, money, interest rate, market and foreign exchange categories:
Year over Year % Change 12/31/2016
Durable Goods -1%
Factory Op Rate -2%
Industrial Prod -2%
Business Sales 2%
Domestic Auto Sales -9%
Factory Shipments -2%
Business Inventoris 0%
Factory Inventories -3%
New Factory Orders -1%
Producer Price index 1%
Construction Spending 3%
New Housing Starts -7%
Fed Funds Rate 11%
Total Loans Outstanding 6%
Total Real Estate Loan 6%
M2 Money Supply 7%
Free Banking Reserves -16%
Interest Confidence Index 6%
Gov’t Corp Yield Spread -23%
Stock/Bond Yield Gap -9%
DJ P/E 31%
Personal Income 4%
Personal Consumption 3%
Pounds per Dollar -18%
YEN per Dollar 2%
3-month T Bills Auc 112%
10 year Treasuries 14%
Dollars per EURO -4%
Consumer spending 4%
Durable consumption -3%
Durable orders 1%
Non Borrowed Reserves -14%
Average NHome price -5%
Median NH Price 0%
3 mo-10 yr spread 2%
Steel Production 9%
Initial Jobless claims -8%
Continuing claims -10%
Avg weeks unemployed -6%
Median Household incom 5%
Mean Household income 5%
Total Banking reserves -14%
Discount window borrow -55%
Petroleum Capacity -2%
Rigs running 0%
Retail Sales 4%
Wholesale sales 2%
Wholesale inventories 0%
Building Contracts 12%
Consumer Confidence 16%
Leading eco indicators 1%
The sustainability of the improving economic trends is critical to an expanding equity market. Monitoring the new data releases on each category as the weeks and months unfold will be extremely important to changes in stock valuations.
The negative market and FX readings are strong causes of concern for if the US economy slows or turns negative in growth, these metrics will move in a direction that could be very painful for investors.