Preservation of Wealth and the Return of Capital

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning June 27, 2016
With Market Questions and Answers

Summary Comments:

The analyst cash flow revisions to their full year 2016 company estimates are arriving and they are not pretty. The political world is feeling tremors in every corner of the globe. Economic results are uninspiring and flat lining, currency markets are volatile, and credit markets are entirely dependent on Central Bank policies.

In this environment we have equities at valuations that are expensive, justified by the “professional” traders as rational because of the pursuit of yield that is best found in dividends versus interest coupons. I see nothing in any of this that tells me this will end well, or that we will escape a dramatic revaluation lower that must happen if we are to rebuild a foundation that is stable and supportive of organic growth. Preservation of Wealth and the Return of Capital is today more important than the Return on Capital. Remember that!

Prior week’s investing activity:

Prudence versus being a Cowboy dominated my investing this past week. Through the close of the U.S. markets on Thursday, I ignored the noise around the UK vote on remaining in or leaving the European Union. Instead I focused on the markets valuation and the behavior of the market coming into the vote. By Thursday I was convinced that being short the market was a winning strategy regardless of the Brexit outcome. Why? Because the pre-vote buying activity by market participants to get ahead of what they believed would be a rally on Friday from a UK vote to Remain would, to me, only result in a buy the rumor sell the news moment given the expensive nature of the market. Profits in this case would be had from selling before Friday even if the UK vote went as the experts projected. On the flip-side, if the vote in the UK resulted in an Exit, the market would sell-off as well. It seemed pretty straight-forward that the correct move by Thursday was to short the market. I did so, and the results are reflected below.

My portfolio’s YTD performance vs the market and its current composition as of June 24, 2016, are as follows:

Connolly portfolio YTD gain as of June 24, 2016 equals + 8.75%
S&P 500 Index YTD loss as of June 24, 2016 equals – 0.32%
NASDAQ Index YTD loss as of June 24, 2016 equals – 5.98%

The Portfolio’s composition as of June 24, 2016 is as follows:
• Cash 44.3%
• Equities 38.0%
• Gold 14.2%
• Fixed Income 3.5%

Forecast for the coming week:

I expect more turbulence in the markets and some form of intervention into the normal operations of the market by governmental authorities. Margin call pressures, portfolio re-balancing, quarter-end positioning, and high degrees of uncertainty in an expensive market indicate to me that we will continue to see pressure to the downside. The likely swings in the market, both higher and lower, could be dramatic, but the overriding path is lower. I will be keenly focused on my portfolio’s position and adjustments to that position given the events to come. With the potential for unanticipated Central Bank actions, one must not get too aggressive and only focused on profiting from a market move lower. Prudence and active management in the near-term is required to protect the value of your Capital. I will act accordingly with a heightened degree of discipline dominating my every move this week. Healthy positions in cash are advisable.

Market Questions and Answers

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

The Dow Jones Industrial Average, the S&P 500 Index, the NASDAQ index and the Dow Jones Transports are all in a downtrend channel. The large declines on Friday brought all of the above noted indexes to points of lower resistance, except for the DJT which broke through resistance. These indexes have been in a decline for more than a year, choppy in action, but in a persistent decline. If the current level does not hold at these resistance points, the declines would become more meaningful. I do not expect the resistance points to hold.

The Relative Strength readings have now declined into the low 40’s and upper 30’s. They reflect a trending market lower as the RS indicators have been declining for the past seven weeks. This is a sign of the market losing momentum as it digests the large increases off of the February lows. The prior highs were not exceeded and the move lower brings into question the market risk of a rush to the exits. I do not see the market as being resilient in its current state, and the level of down points in the RS index are insufficient to indicate a bottom is at hand.

Price Earnings multiples are close to 23.55X for the S&P 500 and 18.60X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT remains in a declining chart pattern. It has been a leading indicator of the broader market. The continued selling of the Transports is a strong negative for the overall market.

The DJU has moved to a new high as investors seek yield reflecting the cautionary investing strategy of a market that poses greater risk then reward for investing in growth oriented businesses. Safety is being sought.

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 71. On Thursday, at the market close and ahead of the Brexit vote, it gave a reading of negative 128 which clearly pointed to an extended and over-valued market that was in need of a correction lower. As an FYI, when we have a high positive reading this is a strong buy signal and when we have a high negative reading it is a strong sell signal. The -71 reading indicates an expensive market. The highest negative reading here was -182 on November 6, 2015. The strongest positive reading was +28.5 on February 12, 2016. Last year at this time (June 26, 2015) the reading was -131, which foretold the summer of 2015 declines in equity prices. We are at a similar place with declining cash flow estimates for the year occurring when high current multiples characterize the market.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 18.16X. This is a relatively high reading of price to cash flow when compared to the historic median of 16.96X. This does not reflect an extreme overvalued market (not a “bubble”) based on historic fundamental comparisons, but in the context of the surrounding economic and market data it is a value that is unsustainable. Additionally, the revisions to the cash flow forecasts that came in this week were strongly negative. The expectation of earnings and cash flows are falling in a market that desperately needs improving operating performance to justify its current value. This does not bode well for equity price appreciation from this point forward.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 71 companies were priced above their DCF value which exceeds the historic average of 61 for the portfolio. This supports an expected fall in the market as more companies have become overvalued and need to correct lower. The market declines on Friday drove the negative DCF count to 67, but the downward revisions of cash flow growth expectations that came in after the market closed pushed the Negative DCF count back up to 71. This is troublesome.

The dollar spread between the Current Price and the Discounted Cash Flow price utilizing 2017 cash flow projections on the 187 Portfolio Companies is now at $19.04. The difference or spread today is below the historic median of $22.42. A higher spread indicates greater value to invest in whereas a lower spread indicates subpar returns will be realized from investing at current prices. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces potential gains absent a significant improvement in future earnings and cash flows.

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

The week’s volume and issues continue to reflect divergent views. Volume tracked the index point declines, supporting the move lower. Issues did not support the move lower, with more issues advancing for the week then declining. My instincts and experience tell me this is a reflection of the one-day large decline in index points that is unbounded as compared to the number of issues that can move on any one day which is bounded. I expect this to resolve itself with volume leading the direction and with issues playing catch-up as more and more issues experience share price declines that better align volume and issues with the broader market index moves.

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

The daily metrics of (1) index point moves being supported by the daily advancing or declining volume, and (2) the index point moves being supported by the daily rising and falling number of issues traded, appear to be in a transition stage from being directionally upward in nature to more neutral. If this persists and soon begins to move with a downward trajectory, it will confirm a move lower in the overall market. This is something to watch in the weeks to come.

Where are the NYSE New Highs and Lows moving toward?

On Friday we reached a total of 75 New 52 week Lows for the day. This is the highest number of daily new lows since February 2016, the markets last bottom, which was more than 1,000 points lower in the DJIA than now. The New Highs and New Lows this past week in both the NYSE and the NASDAQ indicate a loss of upside momentum consistent with the week’s index declines.

How well are Market Tells correlating with Market trading internals?

The technical market internal indicators are moving to be more aligned with the move lower, and are reacting in a way that conforms to a market that needs to correct to address the negative reading in the Market Valuation Tells.

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

The reading is -7. This score reveals a market that is turning lower, one that is showing bear market tendencies in the face of expensively priced stocks and bonds, poor economic results, and a world of increasing political uncertainty. The range is from +7 to -7 and we are at an extreme negative level. Contributors are:

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

Positive in the following areas:
None

Neutral in the following areas:
None

Other:

Bitcoin declined this week to $631 per coin from $760 per coin last week. The continued volatile movement in this digital currency is telling us something important. I believe it is the economic and political turbulence in world markets that is creating buying and selling here, and it reflects a foreshadowing of greater uncertainty and loss of confidence in the Central Banks of the world. Something is happening in the alternative currency sphere that should not be ignored in terms of the implications for the broader financial markets. The per unit value based in the low $400 area over the past four months. Over the past year, the price has increased by over 200% from the $230 area. I hold a position in Bitcoin as we move closer to digital currencies 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.

The Dollar Index now sits at 95.54. Over the past twelve months it has traded between 93 and 100. The dollar has appeared to be range-bound in this area. The latest global economic data failed to indicate economic improvement in the United States and in other geographies throughout the world. Coupling this with the historic moves on Friday in the currency markets, and the likely action in response by the Central Banks of Japan, Europe, China and the U.S., we should see the US Dollar act as a safe haven.

Gold closed the week at the $1,319.10 per ounce. The global turbulence this week in the financial markets and the phenomena of negative interest rates on sovereign debt in many parts of the world are giving support to the price of Gold. In the past week, the Gold and Silver Miner equities rose meaningfully, but less then I would have expected. I believe there is much more room to the upside for these equity holdings. Given the continued global uncertainty and currency volatility issues that exist, I do see material price increases for gold and silver in the foreseeable future and for Gold to advance much higher above the $1,300 level. I will therefore maintain my PM positions to offset potential equity price declines from the broader market.

The Ten-year bond yield closed at 1.56%. We are now at the low yields last seen in 2012 (1.64%). The economic signals I see from the latest government releases show an economy that is contracting. The behavior of the Bond market is confirming that economic slowness. Of concern is a flattening of the yield curve (recession) and the absence of economic activity that a steeper yield curve, if we had one, would indicate. Again, the safety trade of the US is a dominant theme, and yields may fall further as the safety and liquidity of the U.S. market is sought.

Commodities: This week we saw the CRB commodities index fall to 485. The softness in economic demand factors and the rise in the value of the U.S. Dollar are negatives for the pricing of Oil and the Industrial commodities.

The High Yield vs Investment Grade spread made a meaningful move on Friday as it reversed the narrowing and tighter spreads that were indicating Risk-On was the right place to be. We closed this week at a spread of 4.321% and the indication was to take risk-off. Over the past two weeks the range has been 3.94% to 4.352%. The bottoming and potential rise of the HY/IG spread is a negative for equities. High Yield is at 7.125% and Investment Grade is at 2.804%. If the oil market holds the price of a barrel near the $50 mark or higher, the health of high yield market should continue to improve. A fall in oil, which we witnessed this week, will be problematic for the High Yield market and a general negative for the overall market.

That about covers it for this week.

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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