First Quarter 2016 Investment Climate: The Market

The Market

Crossroads present themselves here as well.   The trend of the market indexes and the market internals appear to be in a pattern we have not seen in years.  Since March of 2009 we have been in an unrelenting uptrend.   Corrections have occurred and they have generally been steep and short.  But, if we look out over the past two years of flattish behavior, and the rolling over pattern that began with the last weekly closing high in May of 2015, the market is signaling something new.  Look at the DJIA chart below, a weekly chart going back to 2005.  The foot to the pedal relentless march higher fueled from Quantitative easing introduced to a dramatically oversold condition in March 2009 has faded and we now find the current gas tank reading is very close to empty, as we search for the next gas station amidst the many choices presented by the Crossroads. Given the US economic data discussed above, we may find we are walking and pushing with sheer sweat and muscle a market that needs a spark to turn over the engine one more time.  We need more than Central Bank money creation, currency debasing and interest rate destruction to support the fundamental economic needs and opportunities our world offers.

DJIA

 

  1. Price Earnings: The measure of value represented by the Price Earnings ratio indicates an overvalued market.  Often this is the market’s way of looking forward to accelerating growth, pricing in the optimism of higher profits and revenues from expanding consumption and productivity in the future.  With worldwide economic growth forecasted at sub-3%, the pricing in of optimism may be overdone.  Presently the S&P 500 PE ratio is 22.46X.  The median since 2005 is 18.77X.  The current PE is higher than any point since 2010, and has risen from a bottom on November 25, 2011 of 13.31X.  I find it hard to justify the price in the PE formula and can only conclude at this juncture that price has to come down.  Now, there are some who argue that the market should trade expensively in the current low interest to NIRP environment.  I have looked at this and while some aspects of the argument make sense, in the whole I do not find it credible when all of the pieces are put together.  I will delve a bit deeper on this topic in the subsequent discussion of the 187 portfolio.  One last point to make here which is an important fact:  The rise in the S&P index is lagging the growth in the PE ratio.  This effectively means earnings are contracting when compared to price.  A huge warning sign.
  2. Resistance:  The S&P, DJIA, DJ Transports and NASDAQ are all hitting upper resistance points from the bottom.  I utilize moving averages for each index where I calculate the average, and then create an upward and lower average that surrounds the actual average.  These lower and upper bands have shown to be very reliable bounce points.  Over the past seven years when the indexes have pulled back from their upward advance, invariably the lower bands have proven to be the point where the decline ended and the resumption of the advance continued.  Presently, the opposite is happening.  The January to mid-February trend to the downside of the indexes has just seen a dramatic reversal.  Guess where the indexes now sit?  They are reaching the upward moving average band from below.  If we apply the historic experience of an advancing trend continuing once the lower band was reached as a support level, then the market is now signaling the arrival of an interim top in a downward trending market.  I expect the declining market trend to be confirmed when the indexes bounce off of the upper resistance band, resulting in a falling market in the weeks ahead.
  3. Relative Strength:  The RS indicators are indicating an overbought condition.  The up and down point moves over the past twelve weeks are exceptionally high compared to history.  Individually, they would indicate extremes but combined they have been neutral over the past four or so weeks.  Presently, the downward point measure is shedding the declines from January and this is resulting in a heavier weight on the seesaw from upward points.  Typically, the market will seek to bring the pendulum back to equilibrium, and this foretells a decline in the coming weeks.
  4. Breadth:  The comparison of the S&P and the NASDAQ to the DJIA indicates a narrowing of breadth.  The NASDAQ is presently at 27.25% of the DJIA, down from 29.46% back in September 2015.   The S&P is at a similar point.  Additionally, the advance decline lines of issues have been deteriorating over the past year.  The divergence of the point moves in the indexes to the number of issues advancing vs declining shows a contraction of participation and a narrowing of overall rising companies vs declining companies.  The absence of broad participation speaks loudly to the underlying weakness of the market internals.
  5. New highs and lows:  The net here has been in a declining trend for quite some time.  Presently the last week’s reported net new highs over new lows totaled 139 for the NYSE and 5 for the NASDAQ.  This compares to the last peak of net new highs over lows from June 2014 of 523 for the NYSE and 188 for NASDAQ.  Again, lack of participation by the broader market is telling.
  6. Current Interest Yield Gap:  The CIYG favors stocks over bonds.  In regard to portfolio allocation, the dividend returns from equities is very favorable as compared to the interest coupon from bonds.  The gap today is 1.05% (bonds over equities), which is very low based on historic comparisons.  The median gap over the past eleven years is 2.64%.  Of course, the return of principle profile for equites vs bonds gives a greater risk profile to equities, which indicates that a higher dividend return is needed as compared to interest rates to offset the return of principle exposure.  Should the interest rate environment change and the tightening of credit appear, then the spread will widen and equities will likely face price pressure as portfolio allocations move to fixed income.

 

First Quarter 2016 Investment Climate: The Economy

Economic Factors

  1. New Factory orders, shipments and inventories:  This is a net negative.  Factory Shipments and New Orders have been declining.  Presently, Factory shipments (down $35 billion from recent peak in November 2014) are lower than at any point since March 2012.  New Factory Orders (down $41 billion from recent peak in August 2014) are sitting at levels equal to those we last saw in 2013.  Meanwhile, Factory Inventories are at a record breaking level of $637 billion.   Inventories exceed Orders and Shipments by $170 billion, the largest spread since I have been tracking this data going back to 1990.

 

  1. Business sales and inventories:  Business Sales are at 71.53% of Business Inventories.  The fall in this relationship is dramatic, dropping from roughly 80% back in 2012.  At this point the relative comparisons to the recessionary periods of 2009 and 2002 are on point as they are the only recent periods in which sales represented such a low percentage of current inventories.  Business sales are down $70 billion since the Summer/Fall of 2014, whereas Business Inventories are up $65 billion over the same period.

 

 

  1. Employment:  The persistent and continued improvement here is encouraging.  Weekly unemployment claims, average weeks unemployed, and long-term unemployment are all improving.  Weekly claims, long-term unemployment, and the broadest measure of unemployment (U6) are all below the levels that existed in 2008, prior to the Great Recession.

 

  1. Home prices:  Median ($301,400) and Average ($348,900) New Home prices in the United States are higher now than at any point in the last twenty years.  For homeowners this is very positive and feeds confidence in the area of financial security, and contributes to an overall improvement in consumer confidence.  The however in this area is the lack of rising incomes, which means home affordability is falling.  U.S. Household Incomes, both Median ($53,657) and Average ($75,738), are presently equal to the level that existed in the year 2000.  This is a risk that weighs on the future, for rising home prices that are dependent on low interest mortgage rates will not persist in the absence of rising incomes.  New supply of housing is improving as we move from the low of 500,000 annualized units during the Great Recession to a level of 1.2 million units now.  This is still meaningfully below the 2+ million units in 2006, and approximates the lows of the 1990/91 recession.  Population growth supports a rising housing market, but absent incomes to enable purchases we find we are in a “renters” market vs a healthy expanding housing market.

 

  1. Steel production, Electricity usage, Baltic Dry index:  These are all troublesome if we are looking for signs of positive economic activity that point to self-sustaining vibrancy.  US Steel production at 1.7 million tons is 400 million tons below the levels of 2008.  Electricity usage is relatively flat.  The Baltic Dry index as a measure of Ocean transport has simply collapsed since 2013, falling by over 80%.  We have seen a recent quarter over quarter slight pick-up in the Baltic and will need to watch this for more favorable signs of global trade, however we are still at historically low rates.

 

  1. Domestic autos:  Nice improvement since the recession, as Domestic Auto sales have doubled since 2009.  The current level is still meaningfully below the historic sales levels (we are at 25% of the sale levels that existed in the year 2000), and this indicates a rising age of vehicles in the US and a future demand curve that is hopeful.  Rising incomes, just as in the home price discussion, are needed to unlock greater demand here.  Of concern is the rising level of auto sales being funded by debt over extended lives.  An exhaustion of debt capability should be watched as a limiting factor of continued improvement absent a more meaningful level of economic and income growth.

 

  1. US Construction spending:  Spending on public and private construction in the US has rebounded since the recession, with current levels approximately 50% above the recessionary lows.  Double digit annual growth has been evident here for the past two quarters and this is a real bright spot in economic stimulus.   We are back to 2007 levels in terms of spend. The opportunity for Public works projects to address infrastructure needs of the country is real and meaningful, and this could be seen as a needed catalyst to income levels and overall quality of employment.

 

  1. Lending growth: The rate of growth in lending activity has been moving higher, and could be a sign that the level of Free Reserves in our financial system are slowly starting to react to the continued low level of earning opportunity of money parked within the system.  The annual rate of loan growth is presently running at an 8% level, and has been at this rate of growth for the past three quarters.

 

  1. Dollar Strength:  The strength of the dollar versus other currencies has been volatile but moderating of late.  The rapid rise of the dollar’s strength since 2014 is now moving within a defined band.  From January 2015 thru March 2016 the dollar has traded within a band of 90 to 100.  This compares to the 2014 range of 79 to 90.  Over the past six months the dollar has traded between 95 and 100, mitigating FX impacts on YoY comparisons.  With Central Banks across the globe lowering rates and adding liquidity, coupled with the modest to slowing US economic growth and stated completion of Quantitative Easing by the US Fed, the demand for dollars and dollar denominated assets remains very real.  The impact on US multi-nationals’ forward revenues and earnings should be less dramatic given greater stability in exchange rates.  A lack of currency volatility that may emerge as the new norm going forward should benefit Emerging Markets and the commodity trade.  Additionally, the dollar stability and strength will deliver benefits through greater global expansion of US businesses as dollars are used to finance acquisitions of assets outside the US.

 

  1. Yield spread Investment Grade vs High Yield:  Spreads are narrowing after a blow-out in the first six weeks of 2016.  This indicates less risk is perceived to be in the system from High Yield loans to the commodity borrowers and from European Banks.  The current spread between U.S. Investment grade and high yield corporate debt is on average 4.8%.  The spread between ten year treasuries and intermediate grade Corporate debt is 3.34%.  These are modest premium spreads by historic standards, but are elevated compared to where they stood a year ago (approx. 100 basis points higher).   A flattening of the yield curve is a bit of a concern, as hints of a recession continue to be present.

The Year over Year trend in economic data by quarter is presented below.  The employment data is very encouraging.  The goods and production data is recessionary in tone.  The consumer and construction spending are positives.  Deflation and trade concerns are real

Historic YoY Comp 31-Mar-16 31-Dec-15 30-Sep-15 30-Jun-15 31-Mar-15
DJIA -1% -2% -4% 6% 9%
DURABLE GOODS -2% -4% -3% 2% 4%
DURABLE CONSUMPTION -1% -1% -1% 1% 4%
DURABLE ORDERS 1% 0% -4% -4% 1%
FACTORY INVE -2% -2% -1% 0% 2%
FACT SHIPMENTS -2% -5% -4% -4% -2%
FACTRY OP RATE -3% -4% -2% -1% 0%
NEW FACT ORDERS -1% -5% -6% -5% -2%
BUSINESS SALES -1% -3% -3% -2% 0%
BUSINESS INVE 2% 2% 3% 3% 3%
DOMESTIC AUTOS 1% -15% 1% -1% -12%
CONST SPENDING 10% 13% 14% 5% 2%
NEW HOUSING STRTS 31% 16% 17% 5% 19%
CONSUMER SPENDING 4% 2% 3% 4% 3%
PPI -2% -3% -2% -3% -4%
LOANS 8% 8% 8% 8% 8%
FREE BANK RESERVES -9% -10% -6% -4% 3%
AVG NEW HOME PRICE 0% 14% 4% 5% 8%
MEDIAN NEW HOME PRICE 2% 0% 8% 3% 13%
MEDIAN HOUSEHOLD INCOME -1% 3% 0% 2% 2%
MEAN HOUSEHOLD INCOME -1% 4% 0% 1% 2%
ELECTRIC POWER -4% -2% -2% -6% -3%
BALTIC DRY INDEX -33% -38% -14% -1% -57%
STEEL PRODUCTION 6% -17% -6% -8% -13%
EXPORTS -1% 1% 1% 3% 3%
IMPORTS 2% 6% 5% 7% 6%
INITIAL JOBLESS CLAIMS -10% -2% -5% -13% -9%
CONTINUING CLAIMS -7% -7% -10% -13% -14%
AVG WEEKS UNEMPLOYED -8% -15% -17% -10% -14%
U-6 -12% -13% -15% -11% -13%

First Quarter 2016 Profile of the Investment Climate: An Introduction

First quarter 2016 Newsletter on selected US Economic Data

By: Thomas J Connolly

March 27, 2016

 

“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”….  Theodore Roosevelt

 

My Thoughts

We are at a crossroads with so many intersecting paths before us.  The Global nature of our connectivity has never been more apparent.  Influences of one country’s policies to another, of one country’s events to another, of the speed of information flow across borders, all coalesce around human emotion.  In a calm environment we feel free to choose as our individual preferences lead us.  We act according to our own set of untroubled individuality.  But, throw in turmoil and uncertainty and people move together as a herd, falling back on past lessons and on emotion that is comforted by the sense of consensus.  We become predictable.

The level of uncertainty that abounds around us, the complexity of the crossroads we currently face, are breathtaking.  The volatility of the first three months of 2016 have deep underpinnings.  They have not been solved or cured.  Strong leadership and conviction, coupled with intelligence and respect have never been more important to our future.  We all must recognize the role we need to play to protect life, liberty and the pursuit of happiness.  Our actions as we fulfill our roles, coupled with the information below, may reflect the beginning of an inflection point to a higher place of growth and promise, or a continued glide path lower.  If it is to be higher, we must find the will to be part of a global solution, otherwise we will find that being alone is a very unsatisfactory outcome when it comes to the key principles of human growth and joy.

The following economic data and discussion is like a report card of how we have weathered a great storm.  We have moved away from the dramatic loss of growth that we experienced during the recent Great Recession, but we did not move into a period of sustainable productivity.  That is what I see and what I try to share below.  Central banks have acted as the Emergency Room team, but true recovery will require coordinated global political agreement and action, and that is the true challenge which is before us.  I pray we navigate it well, and that the data sets below find positive change from handshakes across the world and a willingness to work together for the benefit of mankind, as well as our planet.

 

This week’s investment plan as John Fogerty’s “Centerfield” plays in my head

Tom Connolly’s Equity Market Forecast

for the upcoming week beginning March 21, 2016

With Market Questions and Answers

 

Summary Comments:

  • Risk Reward is not favorable for committing money to equities.
  • The March and late February 2016 gains and the January to Mid-February declines are mirror images of one another. This churn has got us back to square one as represented by this Friday’s close and the December 31,2015 indexes.  Seems we ran in place for two and half months, yet pain and gain are alive for many over the period.
  • Over an even longer period, the S&P 500 Index at Dec. 31, 2014 (2058.2) and 2015 (2043.94) approximate the March 18, 2016 close (2049.58).   A stagnant market, yet volatility within the years has hurt some and helped others based on one’s positioning at inflection points.
  • The cumulative advancing and declining volume as of December 31, 2014 versus March 18, 2016 reveals greater selling bias over the period even though the S&P index has been relatively flat.  This indicates that quiet accumulation has been absent for much of the past year or so, while distribution has dominated, and it reflects a weakening in the market’s foundation. 
  • We need a washout over a cleansing period to drive out hope and weak holders in arriving at a market that appropriately values the current lack of economic growth.  
  • The cleansing period will begin the process of creating a new foundation that has eliminated excesses, provided economic incentives through the removal of unnecessary and unproductive regulatory burdens and is therefore reflective of improving economic conditions, all of which is backed by committed and long-term buyers that invest rather than trade.  This will be the sign of the next Bull, and it is absent today.

 

YTD Connolly portfolio gain as of March 18, 2016 equals        +5.56%

S&P 500 Index YTD gain as of March 18, 2016 equals              +0.28%

NASDAQ Index YTD loss as of March 18, 2016 equals              -4.23%

 

Portfolio composition as of March 18, 2016 is as follows:

Equities                  35.7%

Cash                       47.1%

Gold                        13.7%

Fixed Income           3.5%

 

Forecast for the week:   I remain on the less optimistic side of further gains from being long.  Presently, as you can see above, my asset allocation to cash is at a level that I rarely maintain.  However, I cannot, with any degree of confidence, allocate greater funds to long or short positions in this environment.  Why you ask?  Because earning and cash flow multiples are indicative of an overstretched market.  Because individual company assessments show an expanding and greater number of over-valued enterprises.  Because economic improvements are marginal, and measures such as sales to inventories reveal recessionary markers.  Finally, interest rate spreads between Investment Grade and Intermediate Grade bonds show less confidence in the market.  Yet, current momentum is to the upside, and this momentum is now coupled with a declining level of caution by those with dreams of profits in their heads.  What is the adage about solvency and an irrational market (Keynes)?

In this environment I continue to trim my holdings, taking gains, waiting for a future with better entry points.  I maintain a modest E-Mini short position, a healthy allocation to precious metals that is somewhat hedged with put options, and an array of strong dividend generating equities.  As I noted last week, the sidelines are the place to be, and while I wait for the game clock and the field of play at this time of March Madness to give me the signal of a critical juncture, I do keep hearing the John Fogerty “Centerfield” lyrics, “Put me in Coach, I am ready to play, today”.  If only the game felt more balanced.  

I expect some uncertainty to begin to build this week as we move closer to the first quarter earnings’ announcements, and anticipate declines that could accelerate if any of the continuing market concerns trigger emotion that gives reason to step away.

 

Market Questions and Answers

What are DJIA, DJT, DJU, S&P and OTC weekly resistance points telling you?

The DJIA, NASDAQ and S&P remain in neutral territory with 12 week Relative Strength readings still in the 50’s (RS in the 30s and below typically indicate an oversold market while north of 60 typically indicates overbought conditions).  While neutral, it is important to note that 76% of the cumulative 12-week end down points reside in the last four weeks of the 12-week period, and zero down points reside in the most recent four-week period.  Further, after next week, the downside component will lose the dramatic 1,000+ DJIA point decline for the week of January 8, 2016.  This will drive the net RS indicator deeply into overbought territory. 

The NASDAQ 4,200 level (closed Friday at 4,796) still calls out for a visit, and I remain wary of a pullback to this area.  To the upside we are nearing a topping out area of 4,800 to 4,850, so there is less reward then risk from being positioned long.  The S&P 500 is also closer to upward resistance at the 2,060 area (closed Friday at 2,050), with its downward pullback being in the 1885 area.  There is too much resistance in the upper area and too much space below to ignore the higher risk that exists today.  The DJIA is right up against many moving averages and technically will be challenged to continue to advance. The DJT has broken to the upside through near term resistance and is targeting the 8,300 area.  Many moving parts, but the strength in the DJT and the noted strength below in the DJU should not be ignored in assessing the potential for a continued advance higher in the broader indexes.

The DJU continues to be strong reflecting the safety of yield in a nervous world.  It exceeded its prior weekly closing peak this week by closing at 659, a real reflection of low interest rates vs high dividends.  Keep an eye on this index as it presently gives an indication of investor pursuit of safety rather than economic expansion (economic expansion would be evident if electric usage was accelerating thereby driving Utility profitability, which it is not).

 

What is the current score on the Market tells metric?

The Market Tell indicator, which is a comparison of current week metrics to historic means, closed the week at negative 45 as compared to last week’s reading of negative 28 (meaningfully lower than its high of +44.8 on February 12th).   The Portfolio’s Cash flow multiple is 18.29X on expected 2016 full year results and 16.57X based on projected 2017 results.  These are relatively high readings of price to cash flow.  Comparing current prices as the week closed on the 187 portfolio companies to their DCF values indicates 73 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 become overvalued.  I should note that at December 31, the number of companies in this category totaled 72 prior to the January swoon.  The dollar spread between the Current Price and the Forward DCF price on the 187 portfolio continues to narrow and is now at $18.65, pulling back from the February high of $25.14.  It is still above the historic mean of $16.29, thereby confirming the existence of individual undervalued opportunities within the portfolio, but its recent pullback speaks to smaller rewards and higher risks from being long overall at the current levels.

 

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

The week’s volume and issues showed divergences.  On three of the days this week the volume into declining issues meaningfully exceeded the volume into advancing issues.  Money was flowing out of the market in distribution.  In essence, Advancing issues aligned with the index point move higher, but the level of commitment to those issues was lacking in terms of volume of shares traded.  

 

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 volume and (2) index point moves vs issues, showed deterioration each and every day this week as compared to the prior Friday close.  This reflects an aging advance and should be viewed with caution in terms of the advance continuing. 

 

Where are the New Highs and Lows moving toward?

Confirmation of the positive trend continues to be evident as the rotation of declining equities completing their drop shows less new daily lows than what occurred in the prior weeks and a pick-up in new daily highs.  Actual new highs for the past five days were the strongest yet this year (modest based on historic comparisons, but still another new high for 2016).

 

How well are Market Tells correlating with Market trading internals?

Mkt Tell vs Volumes

The market tell is negative and the cumulative 5-day volume also reflects a negative flow in terms of lack of support for the market index advances.   

Mkt Tells vs Issues

The cumulative 5-day issues correlates with the market net movement up indicating a broad based rally, but as noted above one without a complimentary volume commitment.

Relative Strength of DJIA, S&P and OTC

RS indicators are indicating neutral conditions in aggregate, but the sell and buy signals are both at extremes which offset one another to give rise to the neutral reading.  Sell signal will be the next to occur absent a near term market decline as down points roll off of the back end of the period.  Further, the S&P and the NASDAQ showed weakening advances as compared to the DJIA, hence displaying a lack of support from the broader market.

 

What is the CEDATEV reading?

The reading is +1 up from -3 last week.   Contributors are:

 Negative in the following areas:

Valuation

Duration

Positive in the following areas:

Calendar

Environment

Emotion

Neutral in the following areas:

Action

Trend

 

Other:

Bitcoin is at $410, consistent with where is stood last week.  I continue to hold a position in Bitcoin as we move ever closer to digital currencies vs paper money and coinage.  Please note I also own PayPal given the Venmo platform. 

Gold was somewhat volatile on the week and held it’s per ounce price in the $1,250 area.  Miners also performed very well.   I continue to hold a position within the precious metals complex but given the recent gains I have begun to hedge my gains to protect against any pullbacks.  I also bought some Silver miners given the cutbacks in Silver production.

The Ten-year bond yield closed at 1.88%, down materially on the week as risk-on became more pronounced given the Fed’s dovish commentary.

The High Yield vs Investment Grade spread is very supportive of rising equity values.  The spread between HY and IG closed on Friday at 4.545%, down meaningfully from 6.237% in mid-February. The HY closing quote on Friday was under 8% at 7.743% vs 9.624% in February.  This is less elevated and the decline in the gap is a strong net positive. Should it continue to show a narrowing then support for the overall market will be enhanced.  The gap is still 160 basis points above its low set in July 2015, but is nonetheless a favorable mark in the current environment.  Keep an eye on developments in the oil patch for any re-emergence of HY concerns and potential spillover into the broader markets.

 

Have a great week!

 

Tom