Upside Down Environment

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning June 20, 2016
With Market Questions and Answers

Summary Comments:

The level of uncertainty in the world’s financial markets is extremely high. There is no clarity or uniformity of view as to whether we are on the path to a better or worse economic state. The actions of governmental institutions result in less and less positive economic impact. The issues and problems we faced coming out of the Great Recession are still with us but now they appear to be more global in nature. The rates of return on investment today are at minimal reward levels for the risk accepted, more so than at any time in my investment life. I do not have a crystal ball to show me how this will all turn out, but I am finding it harder and harder to see a natural progression to a better economic world from where we are now. Accordingly, I now take on more risk with positions that benefit from falling markets than I do from positions that would benefit from rising markets. We are in an upside down environment.

Prior week’s investing activity: My activity this past week was dominated by buying and selling positions that capitalized on market volatility and in particular market declines. I closed the week with smaller short positions than when I began the week, but a larger volatility position.

My portfolio’s performance and composition for the YTD period ending and ended on June 17, 2016, are set forth below:

YTD Connolly portfolio gain as of June 17, 2016 equals + 5.81%
S&P 500 Index YTD gain as of June 17, 2016 equals + 1.33%
NASDAQ Index YTD loss as of June 17, 2016 equals – 4.14%

The Portfolio’s composition as of June 17, 2016 is as follows:
• Cash 45.8%
• Equities 36.8%
• Gold 13.8%
• Fixed Income 3.6%

Forecast for the coming week: The inconsistencies of the World’s Central Banks in terms of policy and the upcoming Great Britain vote on continued participation as a member of the European Union are holding the market hostage in the face of economic malaise. The general expectation is that the market will rally hard if Britain votes to remain in the Union. If it happens, I do not see that outcome to be of a long lasting positive market dynamic. Accordingly, I may manage my investments early in the week to capture profits that are offered from uncertainty to arrive at a pre-vote position that is more neutral than biased to the downside. After the vote outcome is realized and the market reacts, I will reassess my holdings and invest where I see the greatest value opportunity.

Market Questions and Answers

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

The indexes, other than the Dow Jones Utility average, were all down this week. From a chart perspective the picture is weak, with trends pointing lower.

The Relative Strength readings are now in the 50s, reflecting a trending market lower as the RS indicators have been declining for the past six 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 in the face of any unexpected bad news. I do not see the market as being resilient in its current state.

Price Earnings multiples are close to 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 91. 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 -91 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 19, 2015) the reading was -133, which foretold the summer of 2015 declines in equity prices. We are at a similar place with declining cash flow estimates for the year in the face of high current multiples that yield negative Market Tell readings.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 18.37X as compared to last week’s 18.58X. 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.

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.

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 $18.01. The difference or spread today is below the historic median of $22.41. 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 are caught in this ever swirling change in direction. One day the internals are pointing to support of a rising market to only switch to a divergent position supporting a market decline. This is a very uncertain market that will resolve itself in a way that breaks out of the range either to the upside or downside. The other market and technical indicators lead me to be biased to a breakout to the downside.

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 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 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
Action
Trend
Emotion
Valuation

Positive in the following areas:
None

Neutral in the following areas:
None

Other:

Bitcoin rose again this week to $760 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 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 94.43. 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. 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 $1,301.60 per ounce. 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 moved counter to the move in the metals, yet this seemed more in line with raising cash then a negative indicator of the future price increase of the metals. 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 1.61%. 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. 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%.

Commodities: As this week closed and the dollar weakened, we saw the CRB commodities index rise to 491.32. 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. However, the softness in other economic demand factors may be indicating that this rise is more currency related than vibrancy of demand related.

The High Yield vs Investment Grade spread appears to have formed a near-term bottom. We closed this week at 4.261%. Over the past two weeks the range has been 3.929% to 4.352%. The bottoming and potential rise of the HY/IG spread is a negative for equities. High Yield is at 7.101% and Investment Grade is at 2.84%. 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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