Category: Investment Discussions

Economy

The United States economic indicators have been negative for so long, but in the last quarter of 2016 we see the long awaited change to positive readings. It is encouraging. The positive economic measures are accompanied by positive changes in money and interest rate indicators, with offsets from negative readings in equity market and foreign exchange. So we have a bit of a mixed bag, but do see the blended economic picture as more positive then it has been over the past years.

The economic indicator is a composite of the following factors:

• Durable Goods produced and Durable Goods Orders
• Factory operating rates, inventories, shipments and new orders
• Business Inventories and Business Sales
• Domestic Auto Sales
• Construction Spending and New Building Contracts
• New Housing Starts
• Personal Income and consumption
• Consumer spending
• Average New Home prices
• Baltic Dry Rates
• Steel Production
• Electric Power Usage
• Exports and Imports
• Jobless Claims and Continuing Claims for Unemployment
• Mining and Petroleum Rigs running
• Producer Price Index

Money and Interest Rate indicators are a composite of the following factors:

• Total Loans outstanding in the U.S.
• The M2 Money Supply
• Free Reserves in the U.S. Banking System
• The Federal Funds Rate
• The rate spread between Investment Grade Corporate bonds and Intermediate Grade bonds
• The rate spread between the Ten-Year Treasury bond and Intermediate grade Bonds
• The 3-month Treasury Bill
• The ten year Treasury Bond

The Market indicator is a composite of the following factors:

• The Price Earning ratio of equities
• The yield gap between fixed income coupon payments and dividends paid on common stocks

The Foreign Exchange indicator is a composite of the following factors:

• The UK Pound, China Renminbi, Japanese Yen, and EURO vs the U.S. Dollar

The individual indicator readings of the four categories currently read as follows:
• Economic reading of positive 174
• Money reading of positive 190
• Interest Rate reading of positive 46
• Market reading of negative 260
• Foreign Exchange reading of negative 115

Below is the chart of the year-over-year percentage change in the individual economic, money, interest rate, market and foreign exchange categories:

Annual
% change
Year over Year Change 12/31/2016
Dow Jones Industrial Avg 14%
Durable Goods -1%
Factory Op Rate -2%
Industrial Prod -2%
Business Sales 2%
Domestic Auto Sales -9%
Factory Shipments -2%
Business Inventoris 0%
Factory Inventories -3%
New Factory Orders -1%
Producer Price index 1%
Construction Spending 3%
New Housing Starts -7%
Fed Funds Rate 11%
Total Loans Outstanding 6%
Total Real Estate Loan 6%
M2 Money Supply 7%
Free Banking Reserves -16%
Interest Confidence Index 6%
Gov’t Corp Yield Spread -23%
Stock/Bond Yield Gap -9%
DJ P/E 31%
Personal Income 4%
Personal Consumption 3%
Pounds per Dollar -18%
YEN per Dollar 2%

3-month T Bills Auc 112%
10 year Treasuries 14%
Dollars per EURO -4%

Consumer spending 4%
Durable consumption -3%
Durable orders 1%

Non Borrowed Reserves -14%
Average NHome price -5%

Median NH Price 0%

3 mo-10 yr spread 2%

Steel Production 9%
Exports 2%
Imports 1%
Initial Jobless claims -8%
Continuing claims -10%
Avg weeks unemployed -6%
U-6 -6%
Median Household incom 5%
Mean Household income 5%

Total Banking reserves -14%
Discount window borrow -55%

Mining -3%
Petroleum Capacity -2%
Rigs running 0%
Retail Sales 4%
Wholesale sales 2%
Wholesale inventories 0%
Building Contracts 12%
Consumer Confidence 16%
Leading eco indicators 1%

The sustainability of the improving economic trends is critical to an expanding equity market. Monitoring the new data releases on each category as the weeks and months unfold will be extremely important to changes in stock valuations.

The negative market and FX readings are strong causes of concern for if the US economy slows or turns negative in growth, these metrics will move in a direction that could be very painful for investors.

We now move to the balance sheet

5. Balance sheets matter but do not get enough focus in the media as compared to earnings and stock prices. When balance sheets are combined with the earning and price discussion there is often found very important indicators. One of those indicators is the relationship of earnings before deductions for interest costs, taxes and non-cash charges such as depreciation (”EBITDA”), to the overall Enterprise Value (“EV”). EV/EBITDA is a capacity measurement that is computed by dividing the Enterprise Value (“EV”) of a company (its current stock price multiplied by the number of shares outstanding plus the level of debt the company has on its balance sheet, less the amount of cash the company has that offsets the debt owed), divided by the cash flow power of the company as measured by EBITDA. This calculation creates a view of how well the company can support its net debt burden from cash flows, and gives a relative measure of each company’s degree of access to greater capital needed for growth. A low EV/EBITDA number indicates financial strength as the cash flow is high relative to the level of net debt and the current stock price. A high EV/EBITDA is a cause for caution and should be a trigger for greater analysis of the company and the industry characteristics in which it operates. Creating an historic perspective of this indicator over time as prices change, debt and cash levels change, and business prospects change, provides a key element of overall market valuation levels, particularly when combined with the other observations that have been previously discussed elsewhere in this document. With this as a backdrop, what does the EV/EBITDA metric indicate in today’s market? Of concern is the fact that this metric is at its highest level in the past ten years. The EV/EBITDA ratio is 15.03. To provide some comparative data, consider that the low was set in November 2008 after the Lehman bankruptcy filing when the market value decline caused the ratio to fall to 6.64. Over the past ten years prior to 2016, the average high and low ratio was 12.31 and 9.21, respectively. The current level of 15.03X is a cause of concern, but the driver of this needs to be better understood. If balance sheets are relatively stable in terms of the cash to debt levels, and the high multiple of the EV/EBITDA is driven by a decline in earnings, then the determinant of level of concern would be prospects for higher operating performance in the future to support the market value component of EV. If, however, the debt and cash levels have changed in a way where the companies reveal high EV/EBITDA multiples because debt meaningfully exceeds cash in a way that poses risks to the funding of future growth, then a concern for the high market value of the stocks must be taken into account in assessing prospects for future price increases and the potential risk of a material price decline. This is where a meaningful problem or issue exists in the 2016 analysis. Debt has grown since 2013 by 39% while cash on the balance sheet has only grown by 13% (for the 187 company portfolio, debt has increased in dollar terms by $475 billion whereas cash balances have only increased by $105 billion). Further, cash flow growth over this period has grown by only 16% while prices have risen by 31.5%. So, the balance sheet deterioration in terms of higher leverage and the slowing in earning/cash flow growth are real problems in the current market state. Couple this with the lack of robust projected growth in earnings and cash flow at a time when the balance sheet starting point is weakened creates a very high concern for maintaining the current level of stock prices in the market.

6. The balance sheet discussion and capacity to source additional capital for growth also offers the opportunity to talk to the cost of financing and what if anything we may learn from looking at changes in the cost of capital. The Weighted Average Cost of Capital (“WACC”) is currently at the lowest level in the past ten years. The key driver of the decline in the WACC is the equity component. WACC is a blend of the cost of debt (interest rates) and the cost of issuing shares (required return sought by investors to own shares of stock) weighted based on the proportion of debt to equity levels. Interest rates have been very low since the financial crisis of 2008, so the past eight years have encouraged debt growth as a low-cost source of capital. With the recent rise in interest rates, that low cost source of capital may begin to become more limited. The cost of equity is very much influenced by the perceived risk that investors in equities believe is inherent in owning stock. This equity risk is a price risk as well as a return on investment risk in the form of dividends and dividend growth prospects. When the market is relatively calm, upward trending, and backstopped in the minds of investors by external influencers such as the Federal Reserve or other governmental bodies, then the appetite of investors to pursue equities is large and their demand for high compensation is lowered as they perceive less risk exists. It is in these calm or perceived calm waters that we see aggressive buying of stock with an almost risk-free attitude. Given the world in which we make investment decisions, and the manner in which that world is changing, the question of whether we have more, less or the same uncertainties to consider must be addressed. Presently, the equity component of the WACC has a cost that is below 10%. This is a very low rate of required return. In fact, history would indicate that a rate of 13% or more is a better reflection of the historical cost needed to compensate equity holders for the uncertainty in holding equity vs debt. Given the political and global economic risks that exist in the world today, it must be asked whether the current equity market pricing and demands by investors are reflecting complacency and in doing so are ignoring/mispricing the realities of the risks present in the world? This is a subjective question to some extent, and investor fear or decisions to de-risk often are quick to change in a world where events occur with little forewarning. Pricing the cost of equity capital at a level below 10% in a rising interest rate environment and in the face of a new governmental leader for the United States, coupled with BREXIT, movement in the price of oil, European concerns, and actions by China and Russia, all of which add to uncertainty that arguably is NOT being reflected in the pricing of the equity market should give one reason to pause. Given the speed with which equity investors may pull back from the market should uncertainty be felt as increasing, it may require great caution and vigilance to ensure return of capital is seen as the more important goal then return on capital in the present market place.

More to come……………….

FUNDAMENTAL

The technical picture is one of extremes or approaching extremes that indicate a market reversal/decline is highly likely in order to bring about a more balanced pace of change, a pace of change that is more in line with the historic patterns of the way in which the stock market typically behaves. Extreme states are exceptions, not the norm, and these occurrences resolve themselves through corrections, for as the saying goes, “nothing grows to the sky”, and this current market advance has surely tried to do just that.

The next question is one of magnitude. If we are at extreme levels of technical market behavior which point to a need for a price correction lower, then how large will that correction potentially be? The answer is most likely found within the comparison of current stock valuations vs what may be considered normal market valuations. For this, the assessment is based on the historic relationships of fundamental market factors such as earnings, cash flows, debt levels, interest rates, dividend levels, and overall market return metrics that encourage or discourage further changes in stock prices. The fundamental data that follows indicate we are at an extreme level of valuation indicating the magnitude of the correction when it comes will have the potential to be dramatic in size. Consider the following:

1. Price of equities compared to the cash flow they generate: The historic relationship of stock prices to cash flow produced, which is simply dividing the stock price by the per share cash flow a company earns, averages 17.2 times based on the current year’s cash flow performance, and assuming growth in cash flow in the following year, averages 15.2 times on what the company is projected to generate in cash flow for the following year. Given the rise in stock prices, it would be expected that the growth in cash flow supports the price change thereby maintaining the historic relationship of price to cash flow. Based on the 2016 cash flow results and the 2017 cash flow forecast for stocks, the current price to cash flow relationship now resides at a price to cash flow of 22.29 times for 2016 and 19.59 times for 2017. Clearly we have stock prices that are priced at a premium to the cash they generate. What is the degree of this premium pricing in the current market? It is the highest premium since 2007, in fact it is higher than 2007, and would require an approximate 25% stock price decline to bring the price to cash flow relationship back in line with history.

2. Given the importance of growth in cash flow and earnings to stock prices, what do analysts currently project for cash flow and earnings in this year and for next year? For cash flow, the growth rate for 2017 is 14.03% higher than projected 2016 cash flows. For 2016, the cash flows are actually lower than 2015 by minus 1.95%, so the forecast for 2017 is coming off of a negative growth year (BTW, in December 2015 the cash flow growth projection for 2016 was 12.53%, and that turned into actual negative 1.95% growth). Given the double digit rise in the major stock market indices in the United States for 2016, clearly the poor 2016 cash flow results are not what is driving stock prices. It must be that the projected growth for 2017 far surpasses prior expectations. As noted above, that growth is projected at 14.03%. That growth rate is slightly above the historic projections of growth one year out that has averaged 12.9% over time. Yet even with that above-trend growth rate, stock prices are values at 19.59 times forward cash flow, a very high premium. What about earnings on the S&P 500? For 2016, earnings look like they will only be .6% above 2015, so this has not been a very good year for earnings either. The difficulties in the oil market were a serious depressant on 2016 earnings. What about the forecast for 2017? Currently that forecast is for 12.25% growth over 2016. Healthy, but again not enough when we see this earning growth translated into a price to earnings ratio. If we assume no further appreciation in stock prices, then based on projected 2017 earnings, stocks are priced at 19.35 times. That is a very rich multiple based on history.

Speaking of history, what do we see in terms of projections made and results obtained? In the case of cash flows, the projections have been much higher than the actual results obtained. Since 2009, the actual cash flow generated was 6% below the projection. In fact, for the seven-year span from 2009 through 2016, the actual results have been below the projections in five of those years, and those shortfalls have averaged 9.5% below the projections. Given the track record and the robust 14% cash flow growth projected for 2017, it is hard to see the current stock price environment as reflecting a buying opportunity.

3. Staying on the cash flow theme for one additional point, it is important when valuing companies to look to the cash they generate. Cash flow and cash flow growth over time are critical in assessing investment opportunities; After all, the purchase price of a stock is based on the buyer’s decision to buy an asset with the expectation that the cash the company generates will enable the company to return to the purchaser sufficient cash and/or appreciated business opportunities through re-investing cash to justify the current price paid for an ownership interest. As such, the value of a share today is directly linked to the future cash it will generate. The discounted cash flow model incorporates the expected future cash flows, the growth in those cash flows, and a discount factor to adjust the cumulative value of the future cash for the risks inherent in the uncertainty of tomorrow and for the years (time) it will take to produce the cash. One of the measurements of a given portfolio of stocks is to assess the composition of the portfolio by determining the number of the companies represented within the portfolio that are presently priced below, at or above their discounted future cash flows. Utilizing a pre-existing portfolio of 187 companies as a barometer of the overall market, the historic average of the number of companies that are priced above their DCF computed value lies within the 60 to 61 range. So, at any point in time one can expect that roughly a third of the portfolio is over-valued, while two thirds are fairly-valued or under-valued. This assessment enables buying and selling decisions to be made with the goal always of buying low and selling high. The question today in order to assess whether we are in a normal market or a market that is priced away from the norm is “How much of the portfolio, given current prices and projections of future cash flows, is valued above the historic one third of the portfolio?” The answer is troubling for it indicates we are at extremes that have not existed in the ten years that this portfolio of 187 companies has been tracked. As of Friday, December 9, 2016, 53.5% of the companies tracked are priced above their Discounted Cash Flow price. That level has never been reached (over the past ten year). Further, as a combined portfolio, how does the price of the overall portfolio compare to the overall DCF price? The DCF price of the portfolio is currently $5.99 BELOW the current aggregated price of the portfolio. Historically, the DCF price has, on average, been higher than the current price by $11.29. This indicates a gap of $17.28 ($5.99 plus $11.29) exists, a gap that is larger than any difference seen over the past ten years. To bring the relationship back to normal, current prices would have to decline by 21%, or cash flow would have to increase by 19% above the current projection for 2016 and the cash flow growth rate for future years that was previously projected at 14.03% would have to increase by 20%. The risk in realizing these growth rate improvements is high, and the more likely outcome will be a deep overall market correction to bring values back into balance with realistic company cash flow and earnings growth prospects.

4. Two final points on cash flow need to be included as part of the discussion. The first is a comparison of each year between 2007 and 2015 against 2016. This analysis compares the change in price and the change in cash flow for each year against the current year’s data. For example, there is an expectation that the changes will be correlated such that increases in price will be directly connected to increases in cash flow. This exercise yields results that fit the expectation of a high degree of correlation between the two sets of data. At least it did through December 2015. At year-end 2015, the change in price from 2007 thru 2015 was an increase of 56.98% while cash flow increased by 65.31%. If we also look at 2009 vs 2015, we see a price increase of 80.63% and a cash flow increase of 88.53%. With that as the backdrop, how do the comparisons look when we replace the 2015 data with 2016 data? Here we see the breaking down of the correlation. The comparison of 2007 to 2016 shows a price increase of 81.88%, but only a 62.09% increase in cash flow. For 2009 vs 2016 we see a price increase of 109.29%, but only an 84.86% increase in cash flow. Price expansion is outstripping the growth in operating performance and that would appear to be problematic for sustaining the price increase. While there is an expected growth in cash flow for future periods, the growth estimates would need to be materially higher to bring the long-term price and cash flow change relationship back to their historic correlation. Absent this, the sustainability of the current price increase and the potential for additional price increases in equities is doubtful.

The second point is one of comparing the average compound annual growth rate of price and cash flow. The reason for including this is to assess the impact of the current year’s changes in price and cash flow in the context of history. The expectation is that there should not be a material divergence from year to year in trajectory of these two measures. The average CAGR in price and cash flow for the combined periods 2007 thru 2016, 2008 thru 2016, 2009 thru 2016, up to and including 2014 through 2016, when contrasted with the same calculation that also includes the additional period of 2015 through 2016, reveals a troubling divergence that is not likely to remain unresolved. Through 2014 there is an average CAGR in price of 12.0% and in cash flow of 5.2%. When 2015 through 2016 results are added, the average price CAGR rises to 12.4% but the average cash flow CAGR falls to 4.4%. It is hard to accept that this observation which is being driven by the rise in equity prices in 2016 without a corresponding increase in cash flow is not a warning of a market that is being valued above what a rational buyer should pay for the risk that is inherent in achieving an adequate return on invested capital.

More to come……………….

6. S&P 500, DJIA, DJT, and NASDAQ Momentum Oscillators: Each of these oscillators have been tested against historical data resulting in 24-week measurement periods for each that are based on the best fit of indicator reading to subsequent performance of the index. They are all at or are approaching peak levels that have historically marked the end of a short-term trend move. The oscillator range is 0 to 100. Reaching peak levels of 80 or higher have consistently indicated the end of an up-move. The S&P 500 reading is 91. The DJIA reading is 80. The NASDAQ reading is 89. The DJT reading is 87. I am not a buyer of equities at these levels and my recent actions this week (Monday December 12, 2016) reflected selling of shares in companies I hope to buy back at lower levels in the future. Following the adage of buying low and selling high governs this action.

7. Five-day summation of the DJIA point change compared to the NYSE net change in volume and issues for the week indicate a weakening state. For the prior five days, the DJIA has risen by over 600 points. The corresponding period net advancing volume over declining volume is 565 billion shares. The corresponding period net advancing issues over declining issues is 599 issues. Contrast this present state with the historic averages dating back to October 2009, and we find that there is a lack of underlying support for the index point advance. Historically, the average 5-day advance in points is 198 points, corresponding to average net advancing volume of 807 billion shares and net advancing issues of 2,372 companies. The lack of underlying participation in this index rally is very troubling in the non-confirmation of staying power.

8. Net Annual Advancing Volume as a percentage of total NYSE volume of shares traded is meaningfully above the historic average. Dating back to 2009, and utilizing a year period commencing on October 1 to focus on the seasonality of the fourth calendar quarter as reflective of the most up-to-date earning predictions for the current year and following year, this assessment looks at the relationship of the total net volume of advancing/declining shares traded to the overall volume for the year. On average, the annual net advancing volume over declining volume has measured 2.7% of total annual volume. The range for each year is as follows: 2009/10 = .4% (with a corresponding DJIA rise of 1,238 points); 2010/11 = .5% (with a corresponding DJIA rise of 135 points); 2011/12 = 4.4% (with a corresponding DJIA rise of 2,799 points); 2012/13 = 2.8% (with a corresponding DJIA rise of 1,769 points); 2013/14 = 3.3% (with a corresponding DJIA rise of 1,760 points); 2014/15 = -2.1% (with a corresponding DJIA point decline of 733 points); 2015/16 = 3.2% (with a corresponding DJIA point rise of 1,974 points). For the Y-T-D period from October 1, 2016 thru December 13, 2016 mkt open the percentage is 4.7%. (with a corresponding 1,563 point rise in the DJIA index). Clearly, the relationship that currently exists reflects a robust full year set of positive results, yet we are only a little over two months into the year. A correction will likely come soon to bring into balance the current year with the historic balances, as we presently reflect a full years relationship that is not viewed as being capable of moving much higher given the underlying fundamental market valuations that presently exist.

More to come……………………….

This is a work in process and will have much more to come over the next few days. To kick this off, we begin with some technical momentum indicators, indicators that are very strongly calling for a market turn lower.

Indicator reference sheet and market direction assessment

TECHNICAL

1. DJIA 3% Data: I measure the magnitude and duration of changes in the DJIA when there is at least a 3% change in the index. Currently the DJIA is in an uptrend period. The current movement since the last 3% decline shows a positive Return of 10.13% as compared to the historic average of 9.0%. The time period over which this 10.13% increase has occurred is 5 weeks as compared to the historic 8.8 week average for up periods. This indicates we may be in the late stage of a rally, as this move came off of a 3.73% decline with a duration of 11 weeks, so the up-market was not recovering from a deeply oversold condition that might support a much higher up period beyond the historic average.

2. OTC 3% Data: Currently in an uptrend period. Return is 7.79% vs historic average of 12.50%. Time covered is 5 weeks vs 10.6 week average for up periods. Indicates we may have more to rally. The move higher follows a 5.07% decline (below historic decline average of 9.3%) that took 5 weeks (equal to historic avg). Similar to the DJIA, the market was not rebounding off of a deep oversold condition, so this move higher may run out of gas over the near term.

3. Weekly Relative Strength variances from the Mean indicate an overbought condition:

a. Over the next six weeks, absent new point gains or losses of a material nature, the RS indicators will not move in any notable way. The net weekly up and down changes that will roll off net to zero, with no individual week containing greater than 140 DJIA points.
b. DJIA: We are at extreme levels in the twelve-week RS Up measure and in the RS Sum measure. Both are more than 1 Standard Deviation from the historic mean and absent a meaningful move down, the RS will not change materially.
i. The RS Up indicator resides at 2,076. Levels above 2,000 have occurred 51 times since 2007, a 10% occurrence rate. One Standard Deviation indicating an overbought condition occurs at the 1,818 level. At this time, we are 1.56 SDs away from the mean.
ii. The RS Sum indicator resides at 1,633. Levels above 1,600 have only occurred six (6) times since 2007, a 1% occurrence rate. One Standard Deviation indicating an overbought condition occurs at the 999 level. We are presently 1.88 SDs away from the mean. For the six times in the past ten years where we have been this extended to the upside, within approximately four weeks, five of those periods experienced declines in the 400 to 500 DJIA point area.
iii. The 12 week RS Down indicator currently resides at -443. This is one SD away from the mean and further indicates a condition that is unbalanced given the lack of normal swings in weekly market activity. History has indicated that declines after reaching levels near the -440 area range between 500 and +1,000 negative points over the ensuing 12 weeks.

c. NASDAQ: This index is not as overbought as the DJIA. The RS Sum and Down indicators are mildly overbought, and do not indicate extreme levels at this date. The RS Up indicator does reflect an extreme condition that is 1.72 Standard Deviations away from the Up mean, and is by itself a cautionary indication. There is no appreciable impact over the next six weeks from the rolling off of prior periods, so the current condition will not change absent appreciable point moves in the coming weeks.

4. Relative Strength Oscillators that measure turning points in the market indicate the following:

a. For the DJIA, given its relative stability vs the NASDAQ in terms of volatility, a comparison of the 4-week average and 12 week average volatility has proven to be a quality metric in predicting market turning points.
i. Presently, the RS down measure equals a value of 20 within the defined range of 0 to 100. A measure between 0 and 20 indicates an extreme overbought condition. A measure between 80 and 100 indicates an extreme oversold condition.
ii. The RS Up measure equals a value of 97 within the defined range of 1 to 100. This level strongly indicates an index decline is relatively close in time.

b. For the NASDAQ, the greater volatility requires a longer measurement period to generate a more reliable indicator. Here we utilize a comparison of 4 week changes against 16 week changes in the NASDAQ Relative strength index. The activity and high volatility that has taken place over the past five weeks has placed both the RS Up and RS Down measures at or close to turning points. The RS Down measure is 96 and the RS Up measure is at 75. The only trend change we see is the beginning of a turn to the downside for the RS Down measure, and a continued acceleration to the upside for the RS Up measure. This indicator implies that more time will be needed before a reliable turning point arrives.

5. Daily Factors that contribute to the timing decision of the market continuing or changing its direction, include the following:

a. Daily Volume: The comparison of magnitude of the market point changes to the changes in market share volume often highlight internal support or lack of support for the movement in share prices. Presently, the Volume measure has been exhibiting a declining level of positive volume given the point increase in the stock indexes. Over the last 26 days the DJIA has increased by 2,000 points while the volume point relationship has declined from .90 volume per point to .85 volume per point over the 26 day period of the current market rally. This indicates a weak level of support for the index move higher.

b. Daily Issues: Consistent with the discussion above, and even more pronounced is the relationship of issues advancing versus index point changes. Here the relationship over the same 26-day period has moved from 3.02 to 2.59 which indicates a declining level of participation by the broader market in the index advance. Every time over the past three years, when this indicator has reached the 2.65 level or lower the market has reversed from a high point, typically experiencing DJIA declines of 500 to 2,000 points over the next 20 to 30 days post reaching the 2.65 level.

c. Volume and Issues in a combined comparison for advancing components and separately for declining components indicate a lower level of support behind the index advance. The advancing components are rising but have not attained levels that would be consistent with the magnitude of the index increase. The declining components are falling, but similar to the advancing observation, they have not fallen to levels that would historically be present in an advance of the magnitude we have experiences over the past 26 days.
The above factors do not provide a sense of immediate urgency in regard to a reversal being imminent. That is not to say that the market will not fall in the near-term (month of December), it very well may decline precipitously, however it does indicate that the advance is not well supported, which raises the risk of a material decline within the next eight weeks, if not sooner.

Tom Connolly’s Equity Market Discussion
for the upcoming week beginning Oct 31, 2016
Introduction:
There is a quite a bit to cover and to help you focus on what may be of the greatest interest to you, I am providing an index of the contents of this issue. In this newsletter we will cover the following:

1. Summary Comments
2. Valuation
3. Momentum
4. Economic data
5. Connolly Portfolio

1. Summary Comments:
Before Friday’s revelations of the FBI action investigating HRC emails, I was net short of the market. This net short position reflected Put Options, S&P Futures and individual equity short sales. On Friday morning, I sold some of my long holdings in Qualcomm, General Electric, and Cisco, and continued my buying of Gold and Silver miners while also increasing my holdings of Bitcoin. I took these actions given my view of the equity market being over-valued and the week’s release of 3rd quarter strong results and positive forward outlook for the company New Gold.

After the Friday FBI announcement, I added to my holdings of volatility and increased my net short positions.

In summary, I believe the current equity market is extremely over-valued, has been for quite some time, and is now exhibiting an internal loss of momentum to the upside with increasing downside metrics that portend a material decline. Any catalyst event that ignites a material move from the valuation levels we are presently at is now heavily weighted to the downside vs the upside.

2. Valuation
The most important valuation metrics that I rely upon indicate the following:

a. Price to Cash flow multiple for 2016: The price of stocks trade today at a 20.81X multiple of the projected 2016 per share cash flow they generate. This exceeds the historic median of 17.14X

b. Price to Cash flow multiple forecast for 2017: The price of stocks trade today at an 18.31X multiple of the projected 2017 per share cash flow they generate. This exceeds the historic median of 15.14X

c. Number of equities within my 187 company portfolio that are currently valued above their discounted cash flow value: 84 or 45% of the 187 companies that I track are trading at prices that exceed the discounted cash flow value of each company.

d. Growth in cash flow and price from November 2007: Historically, the growth in cash flow has been closely correlated with the growth in share prices. The recent declines in cash flow during 2016 without a corresponding decline in share price has broken this correlation. When comparing the growth in cash flow and price for each year commencing with 2007, utilizing the month of October data (comparing Oct. 2007 vs Oct. 2016, Oct 2008 vs Oct 2016, etc), we find the divergence of price to cash flow is expanding such that we are valued today as the market was in October 2007, right before the market gave way to a material decline. This divergence must resolve itself at some point. Consider the data:

October 31, 2016 current mkt price and cash flow vs Prior Years
		price		cash flow
		% change		% change
vs 2007		66.80%		66.33%
vs 2008		180.46%		60.88%
vs 2009		118.09%		94.95%
vs 2010		84.16%		43.82%
vs 2011		75.77%		21.15%
vs 2012		69.06%		19.31%
vs 2013		30.92%		16.25%
vs 2014		17.60%		5.36%
vs 2015		5.85%		-0.62%

e. Number of companies within the 187 Portfolio that have declined in price this year: 34% of stocks within the portfolio have a lower price than their December 31, 2015 price. This is up from 27% on September 2, 2016 yet the price of the portfolio has risen. This indicates the advance is becoming more narrow, being led higher by fewer stocks, a typical sign of a market top.

f. Current cash flow growth estimates and trend: The current forecast of year-end 2016 cash flow growth over or under 2015 now shows a .43% decline. In April of 2016 the forecast was for a 6.80% growth in cash flow for the year, and since then every month has seen the forecast reduced until we are now at a negative growth rate.

g. Current market enterprise value divided by Earnings (EBITDA): This multiple is now at 14.06X. A high multiple indicates greater risk. Greater risk arises when the market value of the 187 companies plus their debt less their cash is growing faster than their earnings. The prior record high was on October 19, 2007 at 13.06X. We now exceed the 2007 high.

h. Market decline needed to bring the various valuation measures back to historical averages: A 15% decline is needed within the 187 portfolio to bring the various metrics back to historic averages. A reversion to the mean. Typically, in a major move the market overshoots and goes further then the needed correction. An equity market decline greater than 15%, absent governmental interference, would not be a surprise.

3. Momentum
The various oscillators for the Dow Jones Industrial Average, the S&P 500 and the NASDAQ have all turned with strength to the downside indicating a correction is in process. The current oscillator readings, based on trends in point moves of the indexes, indicate the market has completed its advancing stage and that we now reside in a falling market. The oscillator indicators are meaningfully below the level that would indicate the decline is finished. Every one of the following oscillators are pointing to a further market decline:
1. DJIA
2. S&P 500
3. NASDAQ
4. Relative Strength

The other Momentum indicators are confirming the weakness:

5. New Highs and Lows on both the NYSE and the NASDAQ are pointing to a turn lower: On both a daily and a weekly basis the number of New Highs are declining while New Lows are increasing.
6. Companies on both the NYSE and the NASDAQ that show an increase in price vs a decline in price are falling faster than the indexes: The number of Advancing issues (companies showing higher prices), less the number of Declining issues has swung lower and they are leading the indexes on a downward trajectory. The composite of advancing issues less declining issues is falling faster than the point declines in the Indexes. This is a leading indicator and reflects the opposite of what has existed since the market correction of February 2016.
7. Volume of shares traded on the NYSE are being led by higher volume in declining stocks then volume in rising stocks: Total share volume on days when the market declines is higher than the volume on days when the market rises. This indicates more shares are being sold at lower prices than shares are being purchased at higher prices.

4. Economic Data
The strengthening vs weakening economic data comparisons indicate a weak environment. Summarizing and grouping the data into buckets that reflect what is occurring in the economy, the monetary changes in the US, the interest rate environment within the US, the US equity market trends, and the movement of the US dollar against the currencies of key trading partners, reveal negative trends in all cases other than in the expansion of money. The weighted summary metrics (positive is good, negative is bad) for the following macro-economic measures are as follows:

ECO. IND -108.13
MONEY IND 170.63
INTEREST IND – 23.00
MKT IND -118.50
EXCH INDIC -117.39

5. Connolly Portfolio

The performance of the portfolio at this time is very dependent on rising gold and silver prices and on an equity market decline.

The Connolly Portfolio’s YTD performance vs the market, and its current composition as of October 28, 2016, are as follows:

Connolly Portfolio YTD gain as of October 28, 2016 equals + 3.29%
S&P 500 Index YTD gain as of October 28, 2016 equals + 4.03%
NASDAQ Index YTD gain as of October 28, 2016 equals + 3.65%

The Portfolio’s composition as of October 28, 2016 is as follows:
• Cash 55.1%
• Equities 19.4%
• Gold & Silver 23.4%
• Fixed Income 2.1%

As always, be careful out there.

Tom

Tom Connolly’s Equity Market Discussion
for the upcoming week beginning Oct 10, 2016

Summary Comments:

Beginning to feel like the boy who cried wolf. My assessment of the market remains one of heightened caution. It has been a caution that has not been proven to be profitable, and that fuels doubt as to the value of the financial models that I place so much faith in. While doubt is very much alive, I do not see future success in changing my investment approach. Why?

Because, we are at valuation levels that stop me from investing on the long side of the market. I cannot get caught up in the emotion and money flow into equities in an environment that has more “bubble’ attributes then value attributes. The present state of the market reflects the following summary of extremes:

• Cash flow multiples based on forecasted 2016 results are at 20.90X, a new all-time high in a non-crisis market.

• Cash flow multiples based on forecasted 2017 results are at 18.48X, a new all-time high in a non-crisis market.

• Discounted cash flow values of equities within the 187 Portfolio, as a basket, are now below the current price of the basket. This has never happened before.

• The S&P 500 earning yield is above the 10-year treasury yield by the lowest margin in the past 18 months.

• A full third of the companies that I track have current year cash flow estimates that are lower than the prior year, yet 71% of those companies with negative cash flow growth are actually at prices that are higher than the prior year. Why would a company be worth more today when it is under-performing?

• The momentum oscillators of the DJIA and the NASDAQ are at peak levels that have consistently preceded a downturn.

• The momentum indicators of shares traded in rising stocks versus declining stocks show expanding volume in declining shares now outstripping volume into rising shares.

• New Highs in the market peaked roughly a month or so ago, and while the indexes have been relatively stable or rising, the number of new highs are declining.

• Projected S&P 500 earnings for 2016 are lower than the 2015 earnings by -.03%.

• Forward cash flow growth rates looking out three to five years are at levels meaningfully below the historic average growth rate of 10.85%. Today the average annual growth rate in cash flows over the next three to five years is 8.72%, the lowest level in the past ten years other than the forecasts that existed in 2009 at the height of the Great Recession fear (which were at 7.59%)

• Commodity indexes are rising and reaching breakout levels that point to momentum and asset allocation shifts to emerging markets and commodities, shifts that will divert investments out of US equities.

The above factors keep me in a consistent and similar investment mode of being light on equities, heavy in Gold and Silver, selective in making new investments in commodity related alternatives, and meaningfully weighted toward cash. This portfolio set-up has yielded a below market performance over the past two months, and is testing my patience. For the year, I am now underperforming the broader market given the material declines in Gold and Silver, and while my portfolio is still positive for the year, stronger results would have been realized at this juncture by simply holding the broad market indexes such as the S&P 500. Nonetheless, I remain a believer in the analyses I have undertaken and the view that the level of risk vs reward in today’s equity markets is not favorable and does not warrant increased capital allocations to stocks at this time.

The Connolly Portfolio’s YTD performance vs the market, and its current composition as of October 7, 2016, are as follows:

Connolly Portfolio YTD gain as of October 7, 2016 equals + 1.73%
S&P 500 Index YTD gain as of October 7, 2016 equals + 5.37%
NASDAQ Index YTD gain as of October 7, 2016 equals + 5.69%

The Portfolio’s composition as of October 7, 2016 is as follows:
• Cash 55.7%
• Equities 19.9%
• Gold 22.2%
• Fixed Income 2.2%

Returning my attention back to the market and to the beauty of Fall Foliage in Vermont, I wish you all great success.

As always, be careful out there.

Tom

Year-to-Date returns and Asset Allocation of the Connolly Portfolio
plus
An Analysis of U.S. Equity Market Fundamentals and Technical Indicators
September 17, 2016
by TJ Connolly

SECTION I

The Connolly Portfolio’s YTD performance vs the market, and its current composition as of September 16, 2016, are as follows:

Connolly Portfolio YTD gain as of September 16, 2016 equals + 5.05%
S&P 500 Index YTD gain as of September 16, 2016 equals + 4.66%
NASDAQ Index YTD gain as of September 16, 2016 equals + 4.74%

The Portfolio’s composition as of September 16, 2016 is as follows:
• Cash 55.2%
• Equities 22.3%
• Gold 20.5%
• Fixed Income 2.0%

The portfolio suffered over the past month given the relatively large percentage decline in the Gold and Silver miner equities that I hold in the Connolly Portfolio. The collective decline in the Miners’ share price since August 18, 2016 is 21%. That decline was the main reason the portfolio gains as of August went from double digits to the 5% noted above.

Choosing to own Gold and Silver Miner equities is not for the faint of heart as the volatility in these shares is often dramatic. Given the global dynamics at play from a political and monetary perspective, I strongly believe that continuing to hold these investments will be very rewarding over the longer term. Stomaching the recent declines is not easy, but my thesis still rings true and I continue to expect to be handsomely rewarded by this investment decision.

SECTION II

U.S. Equity Market Fundamentals and Technical Indicators

1. What are the Dow Jones Industrial Average (“DJIA”), the Dow Jones Transportation Average (“DJT”), the Dow Jones Utilities Average (“DJU”), the S&P 500 Index (“S&P”), and the NASDAQ index indicating?

Chart Trends: When charting these indexes on a weekly basis over time, we find that they are all pretty much sitting at support levels. I would not be surprised from a charting perspective to see these equity indexes bounce off of the support levels and head higher. However, this technical picture also poses the risk that should the current support levels not hold, the ensuing declines could be large. I have structured the Connolly Portfolio with a very low level of equity holdings as I do expect a material decline in the overall U.S. stock market.

Relative Strength Readings: Relative Strength is the accumulation of net changes in the individual equity indexes over a period of time. Rising markets increase RS, while declining markets decrease RS. Markets tend to move up and down in a way that present buying and selling opportunities. A rising market is a reason to buy stocks, but if the enthusiasm for owning stocks become excessive with the result that prices have risen too much, we often will see these excess levels identified by very high RS readings. The opposite is true for declining markets. RS readings above 50 indicate a rising market trend, while RS readings below 50 indicate a declining market trend. At levels above 70 or below 30, one must consider whether the buying or selling has become excessive and thereby presenting of an opportunity to profit from a reversal of the excesses. Presently, we are in overbought territory on the RS indicators, with the NASDAQ being the most at risk given its high reading. The NASDAQ reading is 83, the DJIA RS reading is 67, and the S&P reading is 73.

Price Earnings Multiples which allow a relative way of comparing how expensive or inexpensive individual stock prices may be given the earnings they generate are presently at historically very high levels. This means stocks are currently trading at high prices as compared to the earnings they generate when viewed through the lens of past performance. The current PE multiples are 24.75X for the S&P 500 and 19.68X for the DJIA. Why is this viewed as expensive on a historic basis? Consider that since 2005, the median PE for the S&P was 18.88X, while the median PE for the DJIA going back to 1988 is only 18.03X.

The DJT remains in a churning but declining chart pattern. It was modestly down this past week but maybe more importantly it broke below the recent weekly closing low of 7,807 from August 12th. It has been a leading indicator of the broader market over the past two years and should be watched closely for direction of the overall market.

The DJU has been declining since July 22nd. It did move higher this past week as the fears of an interest rate increase began to fade and investors seeking yield went back into the high dividend paying utility sector.

2. What is the current score on the “Market Tells metric”?

I developed a “Market Tell” indicator that treats a portfolio of 187 companies as if they are a single stock. This “stock” is tracked over time to provide an overall sense of whether the “187 Portfolio” is expensive or cheap, and whether there are individual components of the portfolio that present profitable opportunities. The Market Tell indicator principally compares the “187 Company Portfolio’s” current cash flow and valuation metrics to its historic medians. It closed this week at negative 220. This is a very strong indicator that future positive returns from buying equities will be hard to come by.

The 187 Portfolio’s Cash flow multiple based on expected 2016 full year results is 20.24X. This price per share as a multiple of cash flow per share represents the highest reading reached over the past ten years and compares to the historic median of 17.06X. A high multiple such as we have today would be justified if we had accelerating cash flow growth prospects. However, cash flow growth projected for 2016 over December 2015 is only plus 0.68%, basically no growth. What makes matters even more negative is that the cash flow projection as of September 2016 versus the same time last year actually shows a negative or lower cash flow level being produced (minus 1.32%).

Comparing current equity prices to their Discounted Cash Flow values indicates 84 of the 187 companies were priced above their DCF value. The DCF price is the calculation of what a company’s share price should be based on the cash flow it generates, the expected growth in that cash flow over time, and the discounting of that future cash flow by an appropriate interest rate to arrive at a current price that a willing investor should pay to own the value of the future cash to be earned by the company. The current number of companies within the portfolio that have per share prices above their cash flow value is at a new record high. The 187 company portfolio’s historic average of companies that are priced above their DCF is 61 versus today’s 84. This warns of an expected fall in the market as more companies within the portfolio are presently overvalued and will need to correct lower to create a more attractive risk reward profile.

The current per share market price of the 187 Portfolio is $75.66. The DCF price of the 187 Portfolio is $87.25 assuming an annual 13.05% future cash flow growth rate post 2016. The spread or difference in the current price and the DCF price is plus $11.59. This is a good thing, but given the level of uncertainty as to how the future will play out, it is important to consider what the historic difference or spread has been over time. Historically, the forward DCF price is $21.97 above the current price. As the outlook for the future today is no less certain than it has been in the past, the lower spread today is of great concern. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces the prospect of future potential gains from buying stocks at today’s prices.

3. Beyond the pricing of the market, what can we learn from the activity in the market as measured by the volume of shares traded, the number of companies going up or down in price, and the number of companies reaching new highs or new lows in price?

During the post-financial crisis period, I believe we have lived in an investment cycle where investment prices have been elevated through the support of Central Bank policies. Fundamentally, there has been a lack of equivalent economic strength to support current prices, but there has been interest rate reductions and Quantitative Easing policies that have channeled investment resources to equites and bonds. So while the market has appeared to be expensive by historic measures, its internal action has told a story of money flowing into stocks and bonds with the effect of raising prices as if risk was limited. It has been interesting to watch this dislocation that reflects weak fundamental values versus technical strength.

I am taking the time to write this view because something appears to be changing in regard to the technical strength. Specifically, the technical strength now appears to be fading.

Volume: There has been a meaningful skewing of volume such that greater volume is occurring on days when the market moves lower. For example, the net volume on the NYSE (total volume in advancing stocks minus total volume in declining stocks) averaged over the prior 11 days, 22 days, 45 days and 90 days, have all turned lower as negative volume is surpassing positive volume. When I couple this skewing of volume with price action, I find we have been in a declining pattern for the past year, and are presently in another leg down as greater volume is occurring on days when the market declines in an ever increasing pattern.

Issues: The ten-day average of the ratio of the number of companies rising in price versus the number of companies declining in price has now moved to the negative. This is a short-term indication that a new trend may be taking place. Further, the weekly measure of advancing companies and declining companies occurring over a look-back period of the past 49-days has also seen a reversal of trend. The 49-day average of declining issues is expanding while the 49-day average of advancing issues is contracting. This reversal began 3 weeks ago and is accelerating with more and more issues declining.

Stocks reaching New Highs and New Lows over the past 52 weeks: There is a modest expansion of New Lows taking place on a daily basis, and a more meaningful decline in the number of companies making New Highs. This is typically a sign of a market in transition, but it needs more time to play out to validate whether we are transitioning to a weaker market.

4. Other:

Bitcoin has been much less volatile of late. It is valued at approximately $606 per BC. I remain an investor in BC, buying a new coin every so often in order to slowly build a position that I believe may increase in value. There is a cap on the number of BitCoin that can ever be in circulation. Therefore, should it gain greater traction as means of exchange, and therefore become in greater demand, its value in paper currencies such as the US Dollar will rise. I found it interesting the other day when I purchased some physical Gold that the dealer accepted BitCoin as payment. It is worth monitoring. You can do so at a number of websites such as CoinBase or CoinDesk.

The U.S. Dollar Index has been consolidating in the 95 to 96 area. 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. The actions of Central Banks continue to impact the relative values of cross-currency relationships, and it is important to watch the US Dollar given its implications to trade and the pricing of various commodities.

Gold closed the week at the $1,313 per ounce. The global phenomena of negative interest rates on sovereign debt in many parts of the world is giving support to the price of Gold. The recent modest pull-back in the price of Gold in US Dollar terms is not of great concern to me at this time. However, the much more material decline in the equity prices of the Gold miners may offer a true buying opportunity. This potential buying opportunity will only prove real if the price of Gold reassumes its move higher in price. If Gold should decline further, the Miners will follow, so there is risk here that is not insignificant. Keeping a watchful eye on the actions of the Central Banks is important to this investment class of assets. Presently, the dominant view is that the CBs of the world will continue to ease and lower interest rates, as well as provide the markets with additional buying power. The US Fed is scheduled to make an interest rate announcement this week, and it may be prudent to wait to see the announcement of their interest rate decision and their forward guidance before committing new investment capital to work in this area.

The Ten-year bond yield is somewhat static and closed at 1.69%. The economic signals I see from the latest government releases show an economy that continues to operate in a very modest way, presenting signs of continued slowing. I would not be surprised to see a decline in the rate structure given the lack of economic demand and the large supplies of inventory and excess production capacity in the world.

Commodities: This week we saw the CRB commodities index soften. The softness in economic demand factors, the supplies on the market and the stability in the value of the U.S. Dollar are neutral to negative for the pricing of Oil and the Industrial commodities. Deflation remains a concern.

The High Yield vs Investment Grade spread expanded. We closed this week at a spread of 3.52% which is an increase of 52 Basis points over the past week. While still at a modest sized spread, the upturn should be watched as a further expansion will lead to a risk-off environment and a potential large decline in equity prices. The High Yield market is at 6.29% and Investment Grade is at 2.77%. If the oil market fails to hold the price of a barrel near the $45+ level, 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 for this letter.

As always, wishing you great success!

Tom

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning Sept 19, 2016
With Market Questions and Answers

Summary Comments:

It has been close to a month since I last prepared a full newsletter. There are a few things to cover, but the essence of my views remain as previously shared: We are at a level in the equity markets that poses greater risk then reward.

Before I move further into the newsletter, I need to recognize that some friends have commented to me that my writing and subject matter is a bit complex and not always easy to interpret. That defeats the purpose of composing this letter, which is to educate and help others make informed investment decisions. So, I will take a bit of a different tone and approach and would appreciate any feedback from those that wish to help guide me and make this a better tool for all.

First up, where am I allocating my capital, why, and how confident am I about the market’s future direction.

Where am I allocating my capital?

• I have made new investments in Gold, Silver and the companies that mine for Gold and Silver. These investments now represent the largest dollar concentration of my current investments. The actions taken are as follows:

o I have purchased physical Gold in the form of one ounce coins and bars. They are safely stored in a vault. I want some small amount of my precious metal investments to be in physical form and so have done so.

o I have increased my equity investments in precious metal miners by buying the stock of: Alamos Gold, Gold Corp, Harmony Mining, Hecla Mining, New Gold, and Pan American Silver. I have also purchased the right to buy more stock of Gold Corp and New Gold at pre-set prices in the future. I did this by buying what are called “Call Options” on the stock of these two companies.

• I have made investments that will increase in value when the equity markets decline in value. I have principally done this by:

o Selling futures contracts on the S&P 500 equity index at a preset price. If the S&P 500 index declines, I will then have the ability to buy the index at a lower price. My goal, because I believe the equity market is at a level that is too expensive, is to have the selling price I contracted at to be higher than the future purchase price, and this occurs if the S&P index declines below the level of the price I agreed to sell the index. The Future sale price for delivery in the month of December 2016 that I contracted for is 2,130. Presently the S&P 500 Index is at 2,134.

o Buying the right to sell the S&P 500 equity index at a fixed future price. I have done this by buying what are called “Put Options” on the S&P 500 index that lock in a sale price of 2,150. This right expires in late October, so if the index declines between now and then I will profit, but if it does not decline, I will lose the investment premium I paid for the right to sell the index.

o Buying shares in an ETF that goes up in value when the stock market declines and falls in value when the stock market goes up.

o Selling short shares of stock in Netflix and Microsoft. Selling short is a way through your brokerage account that you can profit from individual stock declines in price. Effectively, it is a way to sell a stock that you do not own at today’s price with the expectation that you will be able to buy it back in the future at a price below the price at which you sold the stock. I believe that Netflix is over-valued given the cost of programming it is committed to buy. I like Microsoft and in fact it is a core holding for me. However, its recent run to the above $55 per share price level gave me the opportunity to hedge my position without disposing of the MSFT shares I own in my core portfolio. Should the MSFT price decline, I will lose money in my core portfolio, but will offset that loss by the gain from the short position in my brokerage account.

• I have decided to hold my core equity portfolio steady at its current level. These investments are not held in a trading brokerage account. The investments are through a trustee that enables direct investments in each individual company at levels I choose, some with minimums as low as $10. These company investments enable me to enroll in each company’s Dividend Reinvestment Plan so that quarterly dividend payments are used to buy more stock of the specific dividend payor.

• Finally, my 401-K/IRA account is effectively 100% in cash. I will reallocate this cash to investment choices other than cash when the market has returned to what I consider to be more rational and reasonable values.

Why have I allocated my investment portfolio in the manner described above?

It is because I assess the current equity market to be extremely over-valued. Additionally, I view the low and negative interest rate environment that is supported by the Central Banks of the world to be negative for paper currencies and positive for hard assets such as Gold and Silver. I do not see these Central Bank policies changing anytime in the near future and therefore expect the prices of hard assets to rise in relation to the buying power of paper currencies such as the Yen, the Dollar, the Euro and the Chinese Yuan.

How confident am I in my belief that the stock market will decline from its current levels? I am highly confident that over-valued environments eventually correct to lower valuations. The question of when is the truly most difficult one to answer, but the current movement in the market’s momentum away from an upward direction indicates to me that the decline I expect is not far off. The ground is shifting under the market’s feet and this new instability is the pre-cursor to a market decline that I have been waiting for. This is why my investment positions that increase in value from a stock market decline have expiration dates of October thru December. I expect a material decline during this period.

Hopefully, the above adds some clarity that may have been absent in the prior letters.

As always, be careful out there.

Finally, the detail analysis section that includes my YTD portfolio performance vs the market and the relative measures of market value with trend data will be posted over the weekend after the market closes.

All the best,

Tom

The observations I have shared over the past number of months in regard to the market, which have pointed to an over-valued condition in a supportive technical environment, are unchanged this week. So, rather then write (while I am on vacation) on the subjects I typically cover each week, I thought it appropriate to share my views on momentum and where the market is presently. The headline observation is that momentum is close to or has peaked. Using history as a guide, momentum indicators say it is time to limit exposure from long positions.

Why?

Consider the following:

1) New York Stock Exchange Volume: One of the calculations I perform each week is to compute the five day average of volume on the NYSE. I then compare the current five day period to the prior five day period and take the difference. On a running basis this difference is summed to develop a picture of net volume change over time. This is contrasted with the net point change over time in the stock indexes. The momentum change here is significant as since February 12, 2016 the DJIA has risen by roughly 2,500 points, but the cumulative volume change has lost momentum going from a net positive volume change of 850 million shares to only 115 million positive shares today. The percentage of day-to-day advancing volume and issues over declining volume and issues are supportive of an advancing market, but the decline in overall volume participating in the market points to a market that is losing steam, losing momentum. The decline in net cumulative volume noted above may be criticized in an off-handed manner as not addressing seasonality, but the truth is that last year at this time we were net positive over 900 million shares, so the summer is not the driving force here. It is simply a decline in overall demand that is occurring under the surface.

2) Relative Strength momentum as pictured through variance from the mean (Standard Deviation) is in the tail portion of the curve for both RS moves higher and for RS moves lower. The measures here compute the cumulative DJIA point moves higher for each week in a twelve week period, and separately computes the cumulative DJIA point moves lower for each week in the same twelve week period. This data has been tracked going back to the year 2010. The up move benchmark is 231 points whereas the current SD up measure is at 316 points, indicating we are in the upward end of the tail that will bring about a reversal or a decline to enable a reversion to the mean. For the RS down measure the benchmark is 345 points whereas the current SD down measure is at 166 points, indicating this too is in the tail, but in the low tail end that will bring about a reversal or a surge in downward points to enable a reversion to the mean here.

3) Lastly, the data above is put in context by using an oscillator of Relative Strength. This view is to determine inflection points and to give some sense of timing of when a reversal move may take place. It does not measure the size of the move, only the potential timing and the direction of the move. Over time the RS down oscillator has indicated a turning point lower for the market when the Oscillator reaches a negative 150 point reading. We are presently at negative 145 points. The range of the oscillator over the past ten years for downward Relative Strength is positive 5 and negative 150. At a negative 150, the market has consistently over time reversed its move higher and headed lower within the next one to four weeks. For the upward RS Oscillator, the peak point is positive 50 points, which when reached typically signals a market top is near. The RS Up oscillator hit positive 50 points two weeks ago.

I share the above with you to simply change the focus. It is clear to me that we are fundamentally over-valued to the point of extremes that are setting risk records in my models. That tells me that when we do get a correction lower, it is likely to be very large and steep for we are at stock market levels that have not been historically sustainable, particularly in an economic growth environment that is modest at best. Coupling this extended market condition with the momentum indicators above simply makes me more and more cautious.

As always, be careful out there and have a great week.

Tom