Don’t be surprised if the US Stock Market Cracks

Vitaliy Katsenelson writes about the fragility of this market.

Last week we wrote that the global economy looked good based on PMI numbers. Based on economic numbers since then, that might not be the case. Looking at prices, in China the Producer Price Index (-1.1%) declined and in Germany the Wholesale Price Index declined (-.7%). Looking at production numbers, Germany posted a 1.8% decline, the UK had an industrial decline of .7% and a manufacturing decline of 1.3%, France had an industrial decline of 1.7% and Italy declined by 1.2%. Unemployment numbers were not favorable in Australia and Canada.

However, on the flip side, Composite Leading Indicators continued positive for most countries as reported by the OECD for May, which was the most recent month reported.

MARKETS

The SP500 finished the half up 6%. Most of the gain came in Q2, +4.7%. Volatility continued lower, the VIX dropped to its lowest level since February 2007. T-bonds and Gold were the leading assets classes, up 12.14% and 9.93%.

EMPLOYMENT

At the midpoint of the year the economy is showing some nice improvement. Employment numbers are coming in strong. ADP shows that private, nonfarm payroll increased by 281,000 in June, easily beating the consensus of 210,000.  Construction increased by the most since February of 2006. Online help-wanted ads were up 3.2% in June and first-time ads increased 7%. Unemployment dropped to 6.10%.

GLOBAL ECONOMICS

Global numbers also are improving. Global manufacturing PMI increased to 52.7 from 52.1, the 19th consecutive month of improvement. The US and the UK had the strongest numbers (57.5 and 57.3).

Some notes from this week’s Barron’s.

UP & DOWN WALL STREET

The world is getting tired of living in a US Dollar world. Nations had to deal with the impact of QE no matter if they wanted any part of it or not. QE pushed foreign currencies higher, hurting those countries exports. Countries around the world are now beginning to look for alternatives to the dollar. So another unintended consequence of massive QE is that the dollar slowly loses its place as the world’s currency. This is certainly not good for the long run.

Stephanie Pomboy of MacroMavens says that the decline of former currencies that at one time held a “reserve” status like the USD today, followed the decline of their international standing.

PICKING UP THE PIECES

It was time for the Barron’s round table to get together for their mid-year meeting. Gabelli likes IFF, IPG, CHMT, WFT and MSG.

Bill Gross thinks that if fed funds rate rises to about 2% beginning in mid 2015 through 2017, and not to 3-4% like the market expects, that today’s market valuations “are OK.” Gross likes BBN, PDI and PFF.

Scott Black picked SMCI and PDCE. Black said “The market will continue to rise because it is liquidity-driven. There is little downside risk.”

Brian Rogers said “The market turned rocky for a few weeks in April and is bound to have another rocky period in late summer or early fall.” Rogers still likes AMAT, CNX, CVX, NEM, AVP and PRMSX.

Felix Zulauf is targeting a double digit correction for late summer.

Meryl Witmer picked INGR and TATE.UK. INGR is valued at $91 per share via a 14 multiple on FCF of $6.30 per share plus the FCF from this year. INGR is priced at $75.20.

Fred Hickey is not happy. “The averages are up, but the market isn’t healthy internally. There are many divergences. Big-caps are rising, small-caps are falling. Breadth is terrible. The bullish sentiment of professional investors…is near record highs, which signals trouble…There is big trouble ahead.” Hickey’s picks are gold, silver, AEM and short IBM.

Oscar Schafer likes MFI.CA, RLD and AMRI. AMRI is run by the team that built TEVA. There goal is earnings of between $3 and $4 in about the next four years. The stock sells for $17.

Abbey Joseph Cohen selected SIX and BMY.

Some notes from this week’s Barron’s

UP & DOWN WALL STREET

The slow and steady increase in prices has moved the equity averages to all time highs and volatility to lows. The VIX dropped below 11. Investor’s Intelligence bullish reading is up to 62.20%, second highest on record. Other peaks were 60.8% in August of 1987 and 62% in October of 2007.

SILENT MIGHT

In regards to the low VIX, Ben Levisohn writes that “the lack of heated action might not indicate that something is wrong, but rather that many market participants were just plain wrong. At the beginning of the year, they were nearly united in the belief that the bond yields had to rise, emerging markets would remain weak, and the high-flying, fast-growing stocks had nowhere to go but up. None of that happened.”

THE LINGERING COSTS OF WAR

Big increases in health-care costs for former troops will cause the Defense department to squeeze costs elsewhere which could have a long term impact on defense contractors like LMT, NOC and RTN.

THE PROBLEM WITH VALEANT (VRX)

Vito Racanelli points out that GAAP results “show a history of losses and declining results.” In 2013, free cash flow was negative $4 billion. Debt is up 400% since 2010. EV/Ebitda is about 20.

(Disclosure – short VRX)

GDP for Q1 came in at -1.00%, revised downward from the preliminary estimate of a 0.1% advance. Weather was the main culprit. The economy has since resumed its moderate pace of growth. Employment numbers are generally improving. Other economic reports, while somewhat mixed, still point to continued growth.

Charles Modow of Foundation Capital, an investor in peer to peer businesses, writes about the business.

Click for more

Joseph Paul of Alliance Bernstein argues that the fear of market overvaluation due to the current CAPE ratio is overstated. Click for more.

Up & Down Wall Street

There has been a big rush to buy long-term government bonds, both here in the US and overseas. Long-term rates priced in higher short terms rates than are likely resulting in a yield curve that is too steep. Thus, yields are now moving lower, the opposite of what all the experts thought would happen. Randall Forsyth writes “investors are flocking to safety in the form of low-yielding bonds and so-called defensive stocks sporting high price-earnings multiples. That the true conundrum.”

Hard to Get

HollyFrontier (HFC) – first quarter profit was cut in half from prior year, shares down 5% last week. HFC refines oil in Permian Basin. 2.4% yield with plenty of cash on balance sheet. 11.3x 2014 earnings. Stock can get to $62 (+26%) according to Edward Westlake of Credit Suisse.

A Cheap Play on Alibaba’s Growth

China Mobile (CHL) trades at 11x estimated earnings. Stock has been flat since 2008. Yield is greater than 4% but might drop slightly this year. EV/CF =3.4 based on estimated EBITDA. Government owns 74%. Has been using a 3G network but now rolling out 4G. Has 62% market share in China.

Alibaba needs high speed 4G for growth. Priced at $48 Bernstein analyst Chris Lane has a $67 price target. Matt Ring at Penza says there is “incredible downside protection from both the low valuation and the significant net cash position.”

Risk is that the cash can end up being used for political projects. Minimal FCF this year due to capex.

What the smartest investors are buying now?

Einhorn is short ATHN and said stock could fall 80% from its recent high. Bill Ackman likes FNMA. Larry Robbins likes HUM and WLP. Philippe Laffont was bullish on LBTYA. Zach Schreiber was bullish on VLO and MPC. Jeff Gundlach is bearish on housing stocks. Jim Grant pushed OGZPY. Chris Shumway likes MCO. Mariko Gordon is bullish on EFII, FUL, PCRX. Columbia student Michael Guichon pitched FIATY, trades at 3x EBITDA. Michael Novograts says Brazil can rally if President Rousseff loses in the election.

Flowserve Sees Big Opportunities to Grow

Shares have tripled since 2011 to $75 and trades at 16.9x 2015 estimates but Lee Caleshu of Roosevelt Investment Group see $5 per share next year at an 18 p/e for a $90 price. Earned $3.41 in 2013. Guidance is for between $3.65 and $4.00 this year on a 3 to 6% increase in revenue.

Two Stocks in the Recovery Zone

Brinks was hit with a $122m write down due to currency devaluation in Venezuela. At $25 trades for an EV of 3.8x EBITDA. Competitor Loomis trades for 7x. Jeff Kessler at Imperial Capital thinks margins can get back to 5 to 6% with earnings rising to $1.90 next year. He has a $27 price target.

Big 5 Sporting Goods (BGFV) is down 44% since last May to $12.07. Hurt by falling gun and ammunition sales. Looking to improve margins and comparisons should start getting easier. Mark Smith of Feltl has a $19 price target.

Healthy Profits in Protein

Farha Aslam of Stephens likes Tyson. “Tyson is managed for consistent growth. They have committed to delivering 10% earnings per-share growth annually and to maintaining a very strong balance sheet.”

“They have an active program in place to buy back 34.6 million shares.”

Aslam also likes Pilgrim’s Price (PPC).