The Joy of Investing

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

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning Aug 15, 2016
With Market Questions and Answers

Summary Comments:

I keep a personal diary that captures my feelings about the market. While I write in it often, it is not an everyday event. The other day, as I look back, the words I wrote seem to be the right words for the Summary comments in this weeks’ blog post. So, without further comment, this is what I wrote on August 10, 2016:

“My thoughts and feelings are very mixed. The losses I have incurred from my short positions are large. Fortunately, the gains from my precious metal positions have exceeded the losses on the shorts, providing an overall 11% YTD gain. I am tormenting myself over keeping the short positions. By every measure I track and look to over time to determine points of extreme excess or opportunity, today we are as exposed as ever at a point of irrational heights. Yet the market dynamics of high/lows, of advancing volume and advancing issues all confirm the move higher. A conundrum.

Do I keep the shorts in place after suffering such extreme losses?

Do I liquidate the precious metals after enjoying such extreme gains?

Why have valuation fundamentals become so disregarded by the market?

I am struggling to choose a path.

Best case scenario for my portfolio would be:
1) A serious market correction
2) A continued rise in precious metals

Worst case scenario for my portfolio would be:
1) A continued rise in equity indexes
2) A large decline in precious metals

What do I believe are the odds of each scenario happening?
1) Best Case:
a. Market correction in the current environment 25%
b. Gold and Silver going higher 65%

2) Worst case:
a. Market continues to rise 35%
b. Gold and Silver drop meaningfully 20%

3) Fill to get to 100%:
a. Market is flat 40%
b. Gold and Silver consolidate 15%

Given this perspective, I am going to hold my positions.”

As always, be careful out there.

Prior week’s investing activity: Last week was very much steady as she goes. I trimmed a small amount of the Gold mining position to take some profits off the table, added a little to the S&P September put option holding, and otherwise was very inactive.

My portfolio’s YTD performance vs the market, and its current composition as of Aug 12, 2016, are as follows:

Connolly Portfolio YTD gain as of Aug 12, 2016 equals +10.20%
S&P 500 Index YTD gain as of Aug 12, 2016 equals + 6.85%
NASDAQ Index YTD gain as of Aug 12, 2016 equals + 4.50%

The Portfolio’s composition as of Aug 12, 2016 is as follows:
• Cash 51.7%
• Equities 28.3%
• Gold 18.0%
• Fixed Income 2.0%

Forecast for the coming week: This coming week is the anniversary of last summer’s dramatic decline. The market metrics of July 2015 and July 2016 are twins, and not that last year should guide this year, but the level of overvaluation today is even greater than last year. Best to be careful. For the upcoming week I do not see any driving news or events that will change course. Presently, we have been in a rising market that lacks drama, so my view is to be careful and to not be complacent as this walking on a tight-rope is not for the weak of heart. Being ready to act is paramount as the current market move higher is approaching a length in time that often reflects fatigue and a need to rebalance through a correction.

Market Questions and Answers

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

New index highs dominated the headlines last week (S&P 500, NASDAQ and DJIA), a triple that last happened in the year 1999. The DJU and the DJT did not attend the party and should be kept in our peripheral vision as a cause of potential concern. The trend in overall equities remains higher, but not in a rational way.

Relative Strength: We are in overbought territory on the RS indicators. The DJIA reading is 72, the NASDAQ reading is 75, and the S&P reading is 74. The NASDAQ has moved higher for seven straight weeks. The continued advance has stretched valuations like a rubber band, and any continued move higher will only serve to add tension and power to a potential snap-back event in an overbought and over-valued market.

Price Earnings multiples are 25.27X for the S&P 500 and 20.24X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT remains in a declining chart pattern. It was modestly down this past week while the broader equity indexes rose. It has been a leading indicator of the broader market these past two years and should be watched closely for confirmation of a move higher or indications of a reversal in economic fortune.

The DJU has been churning over the past four weeks around 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.

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

HAZARDOUS WARNING:

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 214. 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 -214 is the highest negative reading I have ever seen. Some of the components are at levels that are scary in regard to over-valuation.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 20.06X. This reading of price to cash flow is the highest reading over the past ten years. If we were experiencing continued rises in growth of future cash flow estimates and rates of growth in cash flow generation then one could justify the high current multiples. However, we just reached the lowest level of cash flow growth projections for the year, now at only a 0.61% growth YoY (August 2016 vs August 2015), and for the full year 2016 vs 2015 the growth is projected at only 1.58%. At some point in time this rising price environment in a declining cash flow growth environment will break.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 84 companies were priced above their DCF value. This is a new record high of the percentage of the portfolio that is trading above their discounted cash flow values. The 187 company portfolio’s historic average of prices above DCF is 61. This warns of an expected fall in the market as more companies are overvalued and will need to correct lower to create a more attractive risk reward profile.

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 $12.29. This is based on a projected cash flow increase in 2017 over 2016 of 13.09%. The difference or spread today between the current price and the DCF price is the lowest in my tracking history and is meaningfully below the historic median of $22.13. 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 have faded in terms of validating the index point moves higher. Of particular note is that the weekly average volume totals are falling to levels unsupportive of the level needed to confirm the strength of the index point moves higher. Declining volume in a rising market is troublesome. This is after taking into account the seasonal phenomena of the summer in the city doldrums and the migration to the beach.

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

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 momentum in new highs vs new lows appears to be tiring. We are seeing a static number of new lows, and a declining level in new highs (note daily new highs are happily in excess of new lows, so there is confirmation of the underlying participation of the broader market in the rally higher, but the gap is shrinking over the past two weeks and warrants paying attention to in regard to whether the participation is beginning to narrow).

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 2 (-2). 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, but the emotion does not show a reversal to the downside.

Contributors are:

Negative in the following areas:
Duration
Trend
Valuation

Positive in the following areas:
Emotion

Neutral in the following areas:
Calendar
Environment
Action

Other:

Bitcoin weathered a storm brought about by the hacking of a Hong Kong based exchange and the theft of millions of dollars of Bitcoin. The price per BTC fell to the mid-low $500s before moving to its current level of $573. 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.

The 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.

Gold closed the week at the $1,341 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. Over the past month, the Gold and Silver Miner equities have risen materially. Results for the quarter ended June 30 were very good, and the action in the $1,300 per ounce area does not show signs of any meaningful pullback. 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 weakened a bit this week and closed at 1.51%. The economic signals I see from the latest government releases show an economy that continues to operate in a very modest way, often presenting signs of continued slowing. 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 stabilize. 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 contracted to give further support to the no-fear environment and the aggressive pursuit of risk for yield. We closed this week at a spread of 3.484% and the indication was to take risk-on. High Yield is at 6.124% and Investment Grade is at 2.64%. If the oil market fails to hold the price of a barrel near the $45 to $50 mark or higher (right now we are rallying to the $45 per barrel mark), the health of the 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. However, right now the HY arena is backing a continued commitment of money to the market.

That about covers it.

As always, have a great week!

Tom

Equity Portfolio as of August 12, 2016

Commentary: The large gains in the Gold and Silver mining equities have marginally exceeded the losses of the short hedges. I have debated reducing the short hedges but given the fact that by every measure I track and analyze, today’s market is priced at a level that offers limited gains from continued price increases. The market is at a level of extremes that pose great downside risk. Of course, emotionally motivated buying can continue to feed the rise in prices, but for this investor it is best to watch from the sidelines and to maintain hedges that will offset the impact of equity price declines. During the week, I modestly increased the short hedges.

Good Luck and have a great week!

New Additions

1. None

Increase in Holdings

1. First Solar
2. S&P September Put Options

Complete Dispositions

1. Alamo Gold

Partial Decrease in Holdings

1. Ultra Short VIX

Overall Equity Portfolio holdings

1. Alamos Gold – Closed position
2. ASA
3. Arm Holdings
4. BB&T Corp
5. Brocade
6. Brookfield Total Return
7. Chevron
8. Con Ed
9. CISCO
10. Disney
11. Eastman Chemical
12. Endo Int’l
13. First Solar – Increased position
14. Ford
15. General Electric
16. Golar LNG
17. Halliburton
18. Harmony Gold Mining
19. Hecla Mining
20. Hershey
21. Ingredion
22. JP Morgan
23. Microsoft
24. New Gold
25. Nordic American Tanker
26. Norfolk Southern
27. Phillips 66
28. Pro Shares Ultra Short S&P 500
29. Pro Shares Ultra VIX Short – Decreased position
30. Qualcomm
31. S&P E-mini short futures
32. S&P 500 September Put Options – Increased position
33. Synaptics
34. Tetra Technologies
35. Travelers
36. Twitter
37. Viacom
38. Wells Fargo
39. Yum! Brands

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning August 1, 2016
With Market Questions and Answers

Summary Comments:

By almost every measure I track, the current equity market is valued at levels that historically have failed to provide near term returns that are positive. The valuation parallels with the summer of 2015 and the summer of 2007 are eerily similar. Whether it is Price/Earnings ratios, Cash flow multiples, Equities trading at prices above their Discounted Cash Flow values, the number of companies that have gone up in price yet have year-over-year cash generated per share that is lower than the prior year, or the dramatic narrowing of the spread between historic mean differentials of current prices when compared to forward valuation measures, I find little data that point to value investing as a condition of the stock choices available today.

We are in a market where I prefer to hold a core equity portfolio that is hedged by short derivatives, and a portfolio where Gold and Silver play an important role to protect against market and global uncertainty.

As always, be careful out there.

Prior week’s investing activity: I added to hedges and maintained the fewest number of equity holdings for the year.

My portfolio’s YTD performance vs the market, and its current composition as of July 29, 2016, are as follows:

Connolly Portfolio YTD gain as of July 29, 2016 equals + 9.17%
S&P 500 Index YTD gain as of July 29, 2016 equals + 6.34%
NASDAQ Index YTD gain as of July 29, 2016 equals + 3.09%

The Portfolio’s composition as of July 29, 2016 is as follows:

• Cash 51.9%
• Equities 30.4%
• Gold 15.7%
• Fixed Income 2.0%

Forecast for the coming week: Fragility is the word I feel most comfortable with in thinking about the forecast for the upcoming week. I believe this market can turn on a dime and head lower in a meaningful way. What will be the catalyst? I have no idea, but the decline from the current heights could be scary.

Given the summer schedule, I will post the details of the market questions and answers later in the week.

Wishing you all the best,

Tom

Equity Portfolio as of July 29, 2016

Commentary: The portfolio below contains the fewest number of individual holdings for the year. By every measure I track and analyze, today’s market is priced at a level that offers limited gains in the future. Of course, emotionally motivated buying can continue to feed the rise in prices, but for this investor it is best to watch from the sidelines and to maintain hedges that will offset the impact of price declines. During the week, I modestly increased hedges and added a small amount of Bitcoin and Netflix shares sold short.

Good Luck and have a great week!

New Additions

1. None

Increase in Holdings

1. Bitcoin
2. NFLX Shares Sold Short
3. Proshares Ultra Short S&P 500
4. Proshares Ultra Short VIX
5. S&P August Put Options

Complete Dispositions

1. None

Partial Decrease in Holdings

1. None

Overall Equity Portfolio holdings

1. Alamos Gold
2. ASA
3. Arm Holdings
4. BB&T Corp
5. Brocade
6. Brookfield Total Return
7. Chevron
8. Con Ed
9. CISCO
10. Disney
11. Eastman Chemical
12. Endo Int’l
13. First Solar
14. Ford
15. General Electric
16. Golar LNG
17. Halliburton
18. Harmony Gold Mining
19. Hecla Mining
20. Hershey
21. Ingredion
22. JP Morgan
23. Microsoft
24. New Gold
25. Nordic American Tanker
26. Norfolk Southern
27. Phillips 66
28. Pro Shares Ultra Short S&P 500 – Increased position
29. Pro Shares Ultra VIX Short – Increased position
30. Qualcomm
31. S&P E-mini short futures
32. S&P 500 August Put Options – Increased position
33. Synaptics
34. Tetra Technologies
35. Travelers
36. Twitter
37. Viacom
38. Wells Fargo
39. Yum! Brands

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:

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:
Calendar
Emotion
Valuation

Positive in the following areas:
Action
Trend

Neutral in the following areas:
Environment
Duration

Other:

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!

Tom

Equity Portfolio as of July 22, 2016

Commentary: I have stripped down this portfolio to its bare necessities. It is streamlined for a market correction, with the expectation that new buying opportunities are best pursued in the future after a healthy market decline takes place. In anticipation of the decline I foresee, I have materially increased Put Options on the S&P 500, Volatility through the VIX ETF, shares sold short on Netflix, and a selected short play on Microsoft post their earnings release. Time will tell if these actions were correct.

The push higher in the market and the weakness in Gold and Silver have hurt my YTD performance as I write this, but that is a price I accept in the short term. It is my expectation that the best strategy at this time is to hold Precious Metal interests and Market short hedges.

Good Luck and have a great week!

New Additions

1. MSFT Bought Put Options
2. MSFT Sold Call Options

Increase in Holdings

1. NFLX Shares Sold Short
2. Proshares Ultra Short S&P 500
3. Proshares Ultra Short VIX
4. S&P E-Mini Short Futures Contract September Expiration
5. S&P July Put Options
6. S&P August Put Options
7. Bitcoin

Complete Dispositions

1. Bank of America
2. Bank of America Preferred
3. Celgene
4. Corning
5. Daktronics
6. Ericsson
7. Greenbrier
8. Integer Holdings
9. IRobot
10. Jabil Circuit
11. JP Morgan Preferred
12. Legg Mason
13. MTN Group
14. Matson
15. Mylan
16. Netflix Put Options
17. Noble Corp
18. Nokia
19. Nucor
20. PayPal
21. Sarapeta Therapeutics
22. Square
23. TenCent Holdings
24. Tessera Technologies

Partial Decrease in Holdings

1. Brocade Communications
2. ENDO
3. First Solar
4. Golar LNG
5. Hecla Mining
6. Microsoft
7. New Gold
8. Synaptics

Overall Equity Portfolio holdings

1. Alamos Gold
2. ASA
3. Arm Holdings
4. Bank of America – Closed Position
5. Bank of America Preferred C – Closed Position
6. BB&T Corp
7. Brocade – Reduced Position
8. Brookfield Total Return
9. Celgene – Closed Position
10. Chevron
11. Con Ed
12. CISCO
13. Corning – Closed Position
14. Daktronics – Closed Position
15. Disney
16. Eastman Chemical
17. Endo Int’l – Reduced Position
18. Ericsson – Closed Position
19. First Solar – Decreased position
20. Ford
21. General Electric
22. Golar LNG – Decreased Position
23. GreatBatch (now Integer Holdings Corp) – Closed Position
24. Greenbrier – Closed Position
25. Halliburton
26. Harmony Gold Mining
27. Hecla Mining – Reduced position
28. Hershey
29. Ingredion
30. IROBOT – Closed Position
31. Jabil Circuit – Closed Position
32. JP Morgan
33. JP Morgan Preferred D – Closed Position
34. Legg Mason – Closed Position
35. Matson – Closed Position
36. Microsoft – Reduced Position
37. MTN Group – Closed Position
38. Mylan – Closed Position
39. Netflix July 15 Put Options – Closed Position
40. Netflix Short Put Options July 22 Expiration – Closed Position
41. New Gold – Reduced position
42. Noble Corp – Closed Position
43. Nokia – Closed Position
44. Nordic American Tanker
45. Norfolk Southern
46. Nucor – Closed Position
47. PayPal – Closed Position
48. Phillips 66
49. Pro Shares Ultra Short S&P 500 – Increased position
50. Pro Shares Ultra VIX Short – Increased position
51. Qualcomm
52. S&P E-mini short futures – Increased position
53. S&P 500 August Put Options – Increased position
54. S&P 500 July Put Options – Increased position
55. Sarepta Therapeutics – Closed Position
56. Square Inc – Closed Position
57. Synaptics – Decreased position
58. Ten Cent Holdings – Closed Position
59. Tessera Technologies – Closed Position
60. Tetra Technologies
61. Travelers
62. Twitter
63. Viacom
64. Wells Fargo
65. Yum! Brands

The market is 1% away from an extreme point of high value. Reward to the upside is 1%, while risk to the downside is 15%. What would you do if while preparing to enter the casino you were told there were even odds you would either lose 15% of your capital or win 1% of your capital? Of course, the odds are not even, and given Central Bank intervention it is impossible to effectively calculate odds. However, in a world of activist bankers, the historic outcomes at these high levels of valuation are pretty consistent. My view, I do not want to lose money by committing new capital to this endeavor. Additionally, I have sold down my trading positions to the lowest levels in my investing history and have meaningful short positions in place.

I will hopefully find the time later today to complete my weekly write-up (currently in the Hamptons’ with family). In the weekly newsletter’s absence, consider this:

Cash flow multiple:

1) Today’s cash flow multiple exceeds the July 2007 CFX.

2) The number of companies within the 187 company portfolio that are priced today above their Discounted cash flow price number 79. The last time we reached this level of overpriced stocks was in December 2015.

3) The spread between the portfolio’s price and the portfolio’s cash flow price is as narrow as it has ever been. Every time we have reached this small of a spread the market has sold off. The four other times since 2006 that we have had such a narrowing were:

a) October 2007 = we know what happened after this (Bear Sterns and Lehman Brothers)
b) April 2011 = 900 DJIA point drop over next eight weeks
c) March 2014 = 400 DJIA point drop over next five weeks
d) July 2015 = 2,000 DJIA point drop over next seven weeks

Be careful out there.

FYI the Connolly Portfolio is up 9.26% YTD.

Have a great weekend,

Tom