The Final Countdown

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning June 6, 2016
With Market Questions and Answers

Summary Comments:

I believe we are in the Final Countdown to a large move one way or the other. A blow-off top or a break down lower that may prove to be dramatic is in the cards. Broad support for a move higher is present and consistent in terms of Advancing Volume and Issues, coupled with New Highs and Lows validating the gains. These facts represent a movement of money into equities that strikes me as being oblivious to the broader economic and fundamental conditions that are clearly not supportive of current equity prices. This type of behavior is characteristic of a next phase blow-off top to bring us to “bubble” territory, a state we are not at presently. It calls for caution and prudence.

Below are the various contributions to the development of my view that we are in a very high risk state. Across the board from: (1) the movement of investing to non-paper means of value (ie Bitcoin, gold, real estate, etc); to (2) the decline in currencies, the decline in bond yields, the declining rates of change in economic measures and the rise in commodities, all undermine the future returns to be realized from holding equities. As you read the individual pieces below, please keep in mind that I do hold a meaningful equity position in companies that provide me a blended dividend yield of over 3%, and as such I do not want to see an equity market decline. But the state of things is such that I have complimented my equity holdings with short hedges and with precious metal investments to offset the potential negative effects of future equity price declines.

Finally, in these summary comments, I feel it necessary to say that the requirements to bring about a high level of confidence that the investing future will be positive and robust are simply not present today. We do not have expanding earnings and cash flows. We have a Bond market and a Foreign exchange market that are signaling problems, yet our equity market behaves as if the highest intelligence in the room, Bonds and FX, have it wrong this time. It is not different this time, and taking the lead from the Fixed income and Currency markets may prove to be the best decision one can make.

Prior week’s investing activity: During the past week I was very active in moving capital amongst various asset classes. I meaningfully increased my precious metal positions on Thursday, while adding to short positions in the option market and in increasing positions that are based on ETFs that profit on market declines and on increases in market volatility.

My portfolio’s performance and composition for the YTD period ending and ended on June 3, 2016, are set forth below:

YTD Connolly portfolio gain as of June 3, 2016 equals +2.72%
S&P 500 Index YTD gain as of June 3, 2016 equals +2.70%
NASDAQ Index YTD loss as of June 3, 2016 equals -1.30%

The Portfolio’s composition as of June 3, 2016 is as follows:
• Cash 47.7%
• Equities 37.2%
• Gold 11.5%
• Fixed Income 3.6%

Forecast for the coming week: I believe we are set-up for a big move and would not be surprised to see it begin this coming week. This past Friday’s US employment report should have been market moving. It was in the fixed income and currency arena, but not in equities. I believe equities are digesting a lot of information and in this state of digestion has not settled on direction. I expect that to be resolved very shortly. The path lower seems most likely from here, however, a blow-off move higher cannot be ignored given the strength of the market in the face of the poor economic data. While both scenarios are possible, my expectation is that we are close to a point in time when the market makes those investors who have been ignoring weakness in the fundamentals to be made to regret being on the long side in an over-weighted fashion.

My focus to improve returns on invested capital will concentrate on the downward turn that is needed to return to a balanced risk reward profile that supports capital investment. If we are to maintain current equity values and possibly increase them, we need an acceleration in revenues and earnings. Should we fail to realize this acceleration the market will reset lower to bring cost of investment in line with desired return on investment. Presently the market projections of earnings and revenue growth for 2016 and 2017 do not reflect the needed growth, so we need surprises to the upside to avoid the anticipated equity index decline that I see as the most likely outcome from today’s levels.

Market Questions and Answers

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

The indexes were mixed this week. Some moved higher, some lower and some stayed relatively constant. This is a market in search of a theme to either move higher more broadly or to reset lower more broadly. Which equity index will prove to be the leader?

The Relative Strength readings remain in the 60s, reflecting a trending market higher (a reading above 50 points to an upward trend). However, the RS readings have been declining over the past month when they previously read in the high 70’s to low 80’s. It should be noted that in five of the last six weeks the DJIA closed lower than the prior week. For the NASDAQ, the moves were evenly split with three up weeks and three down weeks over the past six weeks. Again, who will ultimately lead the other?

Price Earnings multiples are north of 24X for the S&P 500 and 19X 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, and with the rotational trading that has been taking place, a return to the selling of the Transports would be a strong negative for the overall market.

The DJU 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 116, a negative rise from the prior week’s reading of negative 104. 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 -116 reading indicates a very 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 5, 2015) the reading was -82, which foretold the summer of 2015 declines in equity prices.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 18.71X as compared to last week’s 18.57X. These are relatively high readings of price to cash flow when compared to the historic median of 16.92X. 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. Why unsustainable? Because it is one that conflicts with the environment of prior extreme positions from the perspective that those historic positions had economic vibrancy driving the enthusiastic buying of financial instruments, whereas today we have economic malaise in a highly priced market as investors search for returns above the negligible returns of fixed income and other alternative investments. As it has been said, when the tide goes out we find out who is naked from chasing returns that are not based on fundamental value. To this mind, the tide is receding.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 69 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 Discounted Cash Flow Price utilizing 2017 cash flow projections on the 187 Portfolio Companies has narrowed and is now at $16.58, 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 $22.39. 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 were not aligned with the index point moves. The volume and issues over the past five days provide a deepening support for the market to move higher during a week where the market did not advance. This typically presages a meaningful breakout to the upside in the days to come.

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 volume in rising and falling issues, and (2) the index point moves being supported by the daily rising and falling number of issues traded were both meaningfully supportive of a market direction to the upside.

Where are the New Highs and Lows moving toward?

The New Highs and New Lows this past week in both the NYSE and the NASDAQ indicated a continued improvement in market action and a rotation between industry sectors. Signs here point to higher prices given the broadening of participation in the various stock exchanges.

How well are Market Tells correlating with Market trading internals?

The technical market internal indicators are very supportive of rising equity prices whereas the Market Valuation Tells are strongly indicating the need for a price correction lower. At some point either better revenue and earnings will arise to better align value and price or the market will reprice equities lower to bring them in line with their economic value. The economic data that is currently available in the market strongly points to lower prices.

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

The reading is -4 as this rise shows fatigue and topping in the face of an expensive market and political uncertainty. Range is from +7 to -7. Contributors are:

Negative in the following areas:
Calendar
Environment
Duration
Trend
Valuation

Positive in the following areas:
Action

Neutral in the following areas:
Emotion

Other:

Bitcoin rose again this week to $575 per coin. The continued rise in this digital currency is telling us something important. I believe it is the economic and political turbulence in world markets that is creating demand 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 three months. Over the past year, the price has increased by 150% 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 has round-tripped back to the 93 area and now sits at 93.94. Over the past twelve months it has traded between 93 and 100. The dollar has appeared to be range-bound in this area, but the latest global economic data failed to indicate economic improvement in the United States, and likewise softness in other geographies throughout the world, which pressured the dollar lower. We may see the break of lower resistance levels that were last tested a few weeks back. A break under 93 brings us into a void area where there is no support until we get to the 88 area. Additionally, the Chinese currency is pegged to the US Dollar, so a decline in the dollar helps currencies that are pegged to the dollar become more competitive in world trade. This dollar decline eases pressure on the Chinese authorities and Emerging Markets, but exacerbates the global pressures on other non-dollar based countries to compete based on their currencies relative value. Declines in the dollar elicit government responses to lower values of other currencies. This drives investments to non-paper holdings and feeds price rises in precious metals and digital currencies. Paying attention to the movement of the dollar is important given the fragile state of the global economy.

Gold closed the week at the $1,246.50 per ounce, approximately $30 higher than the prior week. The decline in the dollar’s relative value and the view that the Central Banks will continue to ease in the face of slowing economic growth are leading investors to seek the perceived safety of hard assets such as Gold and Silver. In the past week, the Gold and Silver Miner equities rallied. 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 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 1.70% down from 1.85% at last Friday’s close. We are now getting very close to 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. We are below the weekly closing low for the calendar year that occurred on April 8 at 1.72%, and are still below the 2015 year-end rate of 2.27%. Our Central Bank is weighing when to institute another increase in the Fed Funds rate which could be this month. At some point this will likely weigh on the equity markets if the cost of short-term US dollar financing rises.

Commodities: As this week closed and the dollar weakened, we saw the CRB commodities index rise to 488.21, just below the April 29th weekly closing high. We are now at levels last seen in July 2015. This is great for Emerging Markets as they derive so much of their economic wealth from raw material mining and exporting.

The High Yield vs Investment Grade spread continues to appear to be trying to form a near-term bottom. We closed this week at 4.178% as compared to 4.205% last week. Over the past two weeks the range has been 4.115% to 4.298%. The narrowing of the HY/IG spread is a positive for equities as dividend yields push more money toward the stock market then the bond market. Should a bottom be put in and the spread widen, then risk returns in a way that may push the equity markets lower. High Yield is at 7.059% and Investment Grade is at 2.881%. If the oil market holds the price of a barrel near the $50 mark or higher, the health of high yield should continue to improve.

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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