for the upcoming week beginning May 31, 2016
With Market Questions and Answers
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Summary Comments:
My timing was ill-timed this past week. I had a clear view that the market would not move higher in any material way during the week and that the odds were tilted meaningfully toward a decline in the equity indexes. I acted on that view, a view that was and remains well supported by the market’s over-valuation metrics. What did I learn? That I did not have all of the legs of the stool on firm ground to support acting in a material way when the correct call was to act marginally. By being too aggressive I yielded a negative return for the week. Outcomes like this make me go back to the drawing board to learn why. In this instance the question to be answered was “Why was I overly biased that the market would move down and why was that bias misplaced?”
After much thought I came to understand that I needed to compliment my analysis of the current state with a perspective of projected moves and how those potential moves would place the market in the context of past high points and past low points. It is one thing to see the current market as overvalued, but to not include an assessment of how far from the midpoint we are to the outer extremes prevents an understanding of how much the market may comfortably move higher in an otherwise overvalued state, or move lower in an otherwise undervalued state. By undertaking this additional analysis, I found that the market at the beginning of last week was not very far from the mid-point in terms of distance from an extreme high or an extreme low based on historic market ranges. Accordingly, the correct investing stance would have been to remain long of equities with modest short hedges in place that addressed the risk of overvaluation. The actions that I did take to get aggressively short through futures and options was ill-timed and resulted in losses that should have been avoided. We learn through experience from our correct and incorrect decisions, and this week I learned to include another dynamic in my assessment of where the market may move and to use this dynamic to guide me in determining the size of the hedge and risk positions I put in place.
So what is that dynamic indicating after the market index gains of the past week? It reveals a 3% upside is the distance from where market internals peaked at the last high point of November 2015, and an 8 – 12% downside is the distance from where market internals bottomed at the last low point of February 2016. To be clear, the market internal range is not based on prior index point highs or lows, but is based on the fundamental market metrics that existed at the time of those index highs and lows. We now have higher odds of a decline of magnitude versus a rise of magnitude. This supports the short hedges and a pro-active posture to meaningfully increase the risk positions that will profit from a market decline WHEN the other market factors of advancing/declining volume, issues, and New Highs/Lows show alignment with the market fundamentals of valuation. Additionally, it is important to note that the Market Tell indicator (discussed below) is at -104. This is a very strong negative reading and points to future market declines. Presently, for the S&P 500 we have a 60-point potential rise versus a 200-point potential decline. These ranges of potential moves are driven by the current market metrics, indicators, and valuation measures. One should trade/invest accordingly given the high valuation we have when compared to the earnings and cash flow results and forecasts that populate today’s market.
Prior week’s investing activity: During the past week I aggressively purchased Put Options on the S&P 500 and added more short S&P 500 E-Mini futures contracts. On Friday, after incurring losses on these positions, I closed them as I began the process of reassessing the analysis I relied upon to initiate the original investment activity. The Precious metal holdings also were down on the week and contributed to the reduction of the Year-to-Date gain within the portfolio.
My portfolio’s performance for the YTD period ending on May 27, 2016, and the portfolio composition at that date is set forth below:
YTD Connolly portfolio gain as of May 27, 2016 equals +1.43%
S&P 500 Index YTD gain as of May 27, 2016 equals +2.70%
NASDAQ Index YTD loss as of May 27, 2016 equals -1.48%
The Portfolio’s composition as of May 27, 2016 is as follows:
• Cash 46.3%
• Equities 39.3%
• Gold 10.9%
• Fixed Income 3.5%
Forecast for the coming week: Last week I wrote “Yet market internals are not reflecting the voiced concerns, almost acting as if the market wants to catch the largest number of investors as is possible off-sides. Something has to give……….and there is a battle being waged.” This week the market did catch the large number of bearish investors who were short the market, including me. I expect this trend to continue, but as noted above we are approaching an extreme level of high market valuation.
My focus to improve returns on invested capital will concentrate on the downward turn that the fundamentals are indicating 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 likely 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.
What are DJIA, DJT, DJU, S&P and NASDAQ metrics indicating?
All of the indexes moved in a constructive fashion this week. Broad support is present and consistent in terms of Advancing volume and issues, coupled with New Highs and Lows validating the gains (although the NYSE New Highs were a bit lower then I would have expected). Overall trading volume was a bit off but that is typical for a holiday shortened week.
The Relative Strength readings remain in the 60s, reflecting a trending market higher. There is a concern from the perspective of downward contributors approaching a level that historically sets-up for a replenishment decline.
Price Earnings multiples are north of 24X for the S&P 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 come off the recent highs due to profit taking and the potential for rising interest rates.
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 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 -104 reading indicates a very expensive market. The highest reading here was -182 on November 6, 2015.
The Portfolio’s Cash flow multiple based on expected 2016 full year results is 18.65X as compared to last week’s 17.90X. These are relatively high readings of price to cash flow when compared to the historic median of 16.91X.
Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 68 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 DCF price utilizing 2017 cash flow projections on the 187 Portfolio has narrowed and is now at $16.59, 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 $22.47. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces potential gains.
What is the position of the net up down Vol/Issues?
The week’s volume and issues were aligned with the index point moves. Volume was a bit lower than normal but the holiday week impacts this metric.
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 the daily volume in rising and falling issues, and (2) the index point moves vs the daily rising and falling number of issues traded, were supportive of the 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 an improvement in market action and a rotation between industry sectors.
How well are Market Tells correlating with Market trading internals?
The market internals do not reflect any weakening at this point which would indicate a broader concern is emerging for the expensive value of the stocks within the market. At some point either better revenue and earnings will arise or the market will reprice equities to bring them in line with their economic value.
What is the composite reading of the Calendar, Environment, Duration, Action, Trend, Emotion and Valuation Index (“CEDATEV”)?
The reading is -2. Range is from +7 to -7. Contributors are:
Calendar
Environment
Duration
Valuation
Positive in the following areas:
Action
Trend
Neutral in the following areas:
Emotion
Other:
Bitcoin is at $530 per coin and moved dramatically higher this week. The commentary in the market is that heavy buying was taking place in China in an effort to move currency out of the Yuan. The per unit value based in the low $400 area over the past three months. Over the past year, the price has increased by more than 100% 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 rebounded from the 93 area and now sits at 95.70. Over the past twelve months it has traded between 93 and 100. The dollar appears to be range-bound in this area, and the impact of FED tightening by raising the FED Funds rate will likely increase the dollar’s strength. This is problematic for commodities, oil and emerging markets. Additionally, the Chinese currency is pegged to the US Dollar, so a rise in the dollar puts pressure on China, and may elicit a market moving response from the Chinese Financial authorities that would be negative for the equity market. Paying attention to the movement of the dollar is important given the fragile state of the global economy.
Gold closed the week at the $1,216.25 per ounce, approximately $40 lower than the prior week. The metal has been declining. In the past week, the gold miners pulled back and my portfolio reflected the negative impact of that price decline. Given the continued global uncertainty and currency volatility issues that exist, I do not see material price weakness for gold in the foreseeable future and view this decline as a pull-back before another advance higher toward the $1,300 level. I will therefore maintain my PM position to offset potential equity price declines from the broader market.
The Ten-year bond yield closed at 1.85% and has shown a great deal of volatility day-to-day. The prior trend did appear to be leaning toward lower rates but the release of the Fed minutes and the hawkish tone of FED speakers to raising interest rates has had a meaningful impact on the term structure of rates within the United States. 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 above 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 US dollar financing rises.
Commodities: On April 29th the CRB index of commodities rose to its highest weekly closing level since July 2015. This past week, the CRB index was flat.
The High Yield vs Investment Grade spread appears to be trying to form a near-term bottom. We closed this week at 4.205% and over the past month we have been in a declining environment. This narrowing of the spread is a positive for equities as yield plays push more money toward the stock market then the bond market. High Yield is at 7.194% and Investment Grade is at 2.989%. 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.
Watch carefully, and as always, have a great week!
Tom
