Why I Am More of a Bear then a Bull

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning July 25, 2016
With Market Questions and Answers

Summary Comments:

One of the things I learned early on during my investing education was that being right about the market’s state and path was not the same as being right about the timing of when the market would move one way or the other. Timing is elusive, which is why being prudent in deploying risk capital is one of the most important aspects of realizing positive returns. Currently, I am more weighted then I typically am toward a market decline. My fundamental models direct me to not be a buyer of equities today. I am listening to those models, understanding that I may miss upside in a market that is trending higher but one that poses too much downside risk for me to willingly participate. So I am heavily weighted toward cash, and I have been building Put option positions to profit from an equity market decline while limiting capital loss to the premium paid for the options.

So why am I more of a bear then a bull? It is simply based on value (ie Overvalued), a bullish market bias by the overall investing population, an over-bought condition, and the reaching of metrics that have consistently indicated a top in the market. As to the metrics, please consider the following based on the 187 Company Portfolio:

High low data

The above is just a sampling of the Metrics that I constantly assess. The message is clear, at least based on the history of the above moments in time and of the many other market tops and bottoms not reflected in the numbers above, and that is to feel very uncomfortable getting or staying overly long in today’s market.

As always, be careful out there.

Prior week’s investing activity: I simply threw (sold) everything that was not bolted down off of the boat, or whatever craft one wishes to define. I will always maintain a core equity position that I invest around. Today there is no “around” as only the core remains. In addition, I added to short hedges and to Volatility. The short hedges addressed the overall market as well as a couple of specific equities. Cash, Gold, and the Core Equity dominate the present investment profile. While I am happy with the risk reward profile, I must admit that I will suffer declines in returns should the market continue to rise while Gold declines. Obviously, I anticipate the opposite path.

My portfolio’s YTD performance vs the market, and its current composition as of July 22, 2016, are as follows:

Connolly Portfolio YTD gain as of July 22, 2016 equals + 8.16%
S&P 500 Index YTD gain as of July 22, 2016 equals + 6.41%
NASDAQ Index YTD gain as of July 22, 2016 equals + 1.85%

The Portfolio’s composition as of July 22, 2016 is as follows:
• Cash 52.0%
• Equities 30.2%
• Gold 15.8%
• Fixed Income 2.0%

Forecast for the coming week: Softening of some of the technical indicators accompanied by the stretched fundamentals lead me to expect a market that meanders, with upside and downside occurring during the week with little change by the close next Friday. If there is a meaningful move, I do expect it to be to the downside. The Central Bank activities that are upcoming may offer some surprises.

Market Questions and Answers

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

An incredible four weeks of gains for all of the indexes noted above brings us to new highs in all except the NASDAQ and DJT. 1,000 DJIA points, 400 NASDAQ points, and 140 S&P 500 points over four weeks is quite the move. The trend is higher and the breakout is meaningful. It should be noted that this past week was less robust in some of the market internals, but not significant enough to do any real damage to the underlying support for the move higher.

Relative Strength: We have moved into slightly overbought territory on the RS indicators. The DJIA reading is 67, the NASDAQ reading is 68, and the S&P reading is 70. The twelve-week distribution of weekly DJIA gains (a total of 1,600 DJIA closing up points) realized in each four-week period reveals 73% of the gains are concentrated in the most recent four weeks. The last time this happened was November of 2014 after a four week rise of 1,300 points. The market rose another 300 points over the next three weeks before suffering a one-week decline of 700 DJIA points in December 2014. The next occurrence was off of the March 2009 lows. This is a very infrequent occurrence. My take, we are due for a quick and meaningful pullback, but one that is not persistent in duration.

Price Earnings multiples are 25.17X for the S&P 500 and 19.61X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT rose nicely over the past four weeks but remains in a declining chart pattern. It was modestly down this past week. It has been a leading indicator of the broader market and should be watched closely for confirmation of a move higher or indications of a reversal in economic fortune.

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 164 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 -164 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 (July 24, 2015) the reading was -98 after a meaningful pullback from the prior week when the reading was -146, 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 19.36X. This is a high reading of price to cash flow when compared to the historic median of 17.02X. This is very close to an extreme overvalued market (19.72X was last extreme point before a major sell-off). 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 near-term equity price appreciation.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 77 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 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 $14.67. This is based on a projected cash flow increase in 2017 over 2016 of 12.67%. The difference or spread today between the current price and the DCF price is meaningfully below the historic median of $22.28, now reaching a low point for the past 52 weeks. 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 were positive, but in a declining manner when compared to the prior weeks. Something to note and to watch, but at the moment no real cause for concern.

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

Similar to the weekly reading, the daily trend is supportive but in a lessening manner. 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, confirmed the support for the market.

Where are the New Highs and Lows moving toward?

The real concern in the internals this week is in regard to the declining number of new highs in a consistently rising market. On July 11, 2016 we saw 414 Daily New Highs. Since then the DJIA has moved 350 points higher, the S&P 500 has moved more than 100 points higher, yet the New Daily Highs have slowed to the range of 160 to 218 over this continued rising period. The potential canary in the coal mine.

How well are Market Tells correlating with Market trading internals?

The technical market indicators and the Market Tells of valuation are not in alignment. This is an indication that future volatility will arise to bring about a resolution of this imbalance. As we continue to extend gains the level of risk for a dramatic decline to adjust the price of the market to the cash returns from the market becomes increasingly dangerous. Close attention needs to be paid to exogenous events that could ignite a market reversal.

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

The reading is minus 1 (-1). This score reveals a market that has many competing influences. The world events and economic trends coupled with an expensively priced group of stocks and bonds pose significant risk.

Contributors are:

Negative in the following areas:

Positive in the following areas:

Neutral in the following areas:


Bitcoin fell this week to $654 per coin. It recently has been trading in a somewhat narrow band. 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.

The Dollar Index has been firming and now sits at 97.14, the highest level it has been since March. Over the past twelve months it has traded between 93 and 100. The dollar has appeared to be range-bound in this area. A continued strengthening could pose issues for the Emerging markets.

Gold closed the week at the $1,330 per ounce. The global phenomena of negative interest rates on sovereign debt in many parts of the world are giving support to the price of Gold (although it has declined consistently over the past few weeks in what appears to be a corrective move). In the past week, the Gold and Silver Miner equities declined meaningfully. 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 (with modest sized exits and entrances to capture periodic swings above or below a normalized trend) to offset potential equity price declines from the broader market.

The Ten-year bond yield has been firming and closed at 1.57%. We are now at yields that seem irrational given risk reward profiles of return. 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) with only slightly more than a 1% spread between 3 month money and 10 year money.

Commodities: This week we saw the CRB commodities index decline again. 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 contracted to reach prior support and is an indication of a perceived low level of risk in the high yield market. This is also supporting the rising equity market and the risk-on trade. We closed this week at a spread of 3.546% and the indication was to take risk-on. High Yield is at 6.233% and Investment Grade is at 2.687%. If the oil market fails to hold the price of a barrel near the $50 mark or higher (right now we are fighting to hold onto $44 per barrel), the health of high yield market may once again show pressure. A fall in oil will be problematic for the High Yield market and a general negative for the overall market.

That about covers it.

As always, have a great week!


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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