Our 2015 forecast for the domestic economy appears to be valid and is supporting the current prevailing direction. We were not the most popular forecaster back in 2015, but we did not see the underlying support in global economic activity that many others had wished. The probability is still highest for slow and steady economic growth that will move the domestic market in a fair value range between a high of 23,897 and a low of 14,706 with the highest probability of movement between 22,059 and 16,544. Within the next twelve months we expect the DOW to trade between 22,349 and 18,285. From the current level of 17,615 the market should improve by approximately 15%. Over that period the low side of the forecast is an improvement of 3.8% and the extreme high side is nearly 26%. If the market reaches a growth level of 26% within the next 12 months it will clearly be overvalued by the time it reaches 22,349. The most likely level is 20,317 by this time next year (2016).

Screen Shot 2015-08-13 at 2.34.15 PMDifferent Sectors

Dow Industrials: DOWI


At the present time the market is 96% of fair value with plenty of room to move to the upside. The first part of 2015 has placed rather extreme pressure on the downside with a slow start due to weather, a steady decline in energy raw material prices, a potential breakup of the Euro Zone and possibly a Greek default on debt. These are not insignificant events and the fact the market and economy has not experienced a deep decline is a credit to the underlying strength of global activity. The market reminds someone that knows things are better than they appear. This has been clearly displayed in the market as it has moved sideways from the first of the year. The overall market is currently below our forecast, but we expect it to catch up over the next twelve months. Individually the sectors are behaving very independently. It is no surprise energy is the most negative while healthcare continues to move into overvalued territory. Each of the sectors are looked at in terms of asset allocation and relative valuation in the paragraphs that follow. The DOW constituents are mostly trading within fair value. The most undervalued stock is Chevron at 75% of fair value. It is no surprise that the most undervalued stock would come from the energy sector. The most overvalued stock is NIKE at 132% of fair value.

Consumer Discretion Sector: XLY


CONSUMER DISCRETION: is a major sector that represents 12.8% of the large-cap domestic stock market. It is currently undervalued slightly by about ½ of a percent point. While that is not a large percentage gap between the fair value allocation and the market weight allocation it does represent an interesting position. Stocks in this sector are familiar names such as: Netflix, GM, Ford, The GAP and Mattel. Consumers do not necessarily “need” these products, they are at the discretion of the purchaser. Many times these stocks do not perform well until there is a clear upward movement in the stock market and a strong growing economy. At this point in the market it is fairly easy to see why investors may be hesitate to invest in companies that are dependent upon consumer confidence. The consumer is currently uncertain. If you take a look at the chart on consumer discretion you will see a sector that has moved upward on a steady basis along with the market over the past 5 years. Only recently has the sector actually outperformed the overall market. The recent better performance is shown in the gap that is starting to appear between the market (red line) and the consumer discretion sector (blue line). This activity started in May of this year when the overall market started to drop. The earnings of consumer discretion stocks warrants a higher value than the current $78.18 (XLY) and should be about a half a percent higher. An investor will benefit over a longer term if weightings in the portfolio are increased from the current market level of 12.8% to 13.3%. This is a slight adjustment that has a high probability of adding value to a portfolio.

Consumer Staples Sector : XLP


CONSUMER STAPLES: is the other side of the consumer equation. These products represent more necessary items that are difficult to avoid over a long period of time. The sector is represented by companies such as: Whole Foods, Procter & Gamble, Colgate-Palmolive and Molson- Coors. These companies are usually insulated from sharp movements in the stock market, especially downward movements. The same type of gap that is developing in the consumer discretion sector is appearing in the consumer staples sector. The gap started sooner, April of this year, and has become larger more recently. The gap in earnings and stock fair value is about the same as consumer discretion, but it is in the opposite direction. The gap is toward the overvaluation side. The gap is not large, but it does present an interesting position. Many times investors will have higher confidence in staples over items of discretion when the market is in an uncertain position. That is exactly what is happening in this case. Consumers need the products offered by the staples sector and investors have more confidence in their performance. At the moment it is a slight overconfidence resulting in an overvaluation. Most of the stocks in this sector are in fair value ranges or on the higher side of fair. A few are considered overvalued such as: ConAgra, Walgreens, Dr. Pepper and Monster. (For brevity I will use the more common name for companies that have merged into entities that cannot make up their minds as to the new name of the enterprise. I don’t understand what is gained from having the longest name on the list. Maybe they sell ink.)

Energy Sector: XLE


ENERGY: has made the biggest change in valuation this quarter and how quickly the environment can change. Until April 2014 energy stocks were moving right along with the overall market like good dance partners. Then a breakout to the upside started when economic projections were being revised to the upside. In June 2014 supply numbers started to outstrip demand as U.S. shale production became mainstream. Brent and West Texas crude prices started to drop and OPEC decided not to reduce production gambling for stable market share. The drop has created a large, 1.31 percentage point undervaluation for energy stocks. Earnings support a much better share price overall. Yes, some energy companies are impacted negatively as enterprises support market share positions and pricing squeezes earnings. Others are able to delay capital investments, modify production and reduce future exploration. Investors have reacted more cautiously than necessary, just as in the market decline of 2008, resulting in a 14% undervaluation. Fear of unknown supply is causing investors to move away from energy stocks in the short term. It is a great buying opportunity in the right stocks. You can see from the energy sector chart the dramatic downward movement in the sector. Even with adjusted fair values that reflect new energy prices stock market prices are well below fair value and into undervalued positions. Demand for energy has remained stable. Over the long term, the stock prices will come back to fair values and above, representing nice gains. This is not a short term profit picture. It is a longer term growth based on economic activity across a global basis. Some of the most undervalued companies are: Chesapeake Energy, Southwestern Energy, Halliburton, Marathon Oil and Chevron. The energy market is below our forecast from late 2014 but dividends are good and the investment has a high probability of performing well over the next twelve months.

Financial Sector: XLF


FINANCIAL: stocks have been performing as expected and are at nearly fair value of $24.77 (XLF). These stocks represent the second largest weighting at 16.6% in the market, and hold a valuation of 16.3%. There are three sectors that are very close to their fair values and this is one. In the chart you can see how the sector has moved in lock-step with the overall market until very recently. The recent diversion is based entirely on the downward movement of energy stocks. Energy stocks have moved the market downward while financial and other stocks have continued to move upward. There are several stocks that are undervalued. The three that are the most undervalued are: Unum (UNM) an insurance company at 38% fair value which can be viewed at: UNUM Group Chart.  The second is HCP (HCP) at 75% fair value which is involved primarily with healthcare real estate and can be viewed at: HCP Inc. Chart.  The third undervalued security is Ventas (VTR) at 76% fair value which is also involved with healthcare real estate and can be viewed at: Ventas Inc. Chart.

Healthcare Sector: XLV


HEALTHCARE: represents the other side of the equation with strong overvalued positions. Some of the most overvalued stocks in the sector include: Aetna, HCA, Boston Scientific and Mallinckrodt. They are good companies. The concern is that the current stock price is well above the company’s fair value. Expectations are too high for the company and it will be difficult to deliver on these lofty expectations. When this is realized the stock price should come down closer to fair value, or below into undervalued areas. Right now the sector is almost 0.7 percentage points over fair value. This is not an exceptionally large amount but it is near the 1 percentage point level. When sectors move beyond 1 percentage point either above or below the gap with market weights the sector asset allocation is adjusted. Just because the sector is overvalued does not mean there are no undervalued stocks to be obtained. There are a few such as: Biogen and Merck. Both of these companies are more than 20% undervalued and represent good potential. The sector has been performing at the upper levels of our forecast. The probability for this to continue is muted somewhat for the remainder of 2015. One of the most overvalued securities in healthcare is Aetna (AET). This is primarily due to constant merger activity. The chart can be viewed at: Aetna Inc. Chart.

Industrial Sector: XLI


INDUSTRIALS: have struggled since February after enjoying a steady growth run beginning in late 2012. Where most of the sectors have formed a gap between the overall market, industrials have move along with the market, but at a slower rate. Industrials are a mix of well-known names and some not so well known. On the list are: CSX, United Technologies, GE, Southwest Airlines and 3M. Many of these companies are impacted both directly and indirectly by economic growth in the energy related fields. Many of the customers of industrial companies are energy refiners and explorers. The sector is currently at the lower end of our forecast and we expect the companies of the sector to improve as overall economic conditions stabilize and improve.

Technology Sector: XLK


TECHNOLOGY: stocks have lagged the overall market since 2009 but started closing the gap, ever so slowly, since mid-2013. Once the catch-up was completed around mid-2015 both the sector and market have been walking together. Even the recent downward movement in the market has been mirrored in technology. This is a hard sector to see with a broad view because the largest company in the market, is in the sector. Apple now represents 3.7% of the largecap U.S. market well ahead of the #2 company, Microsoft at 2.06%. Apple has not enjoyed a stable rise this year. In fact, the sector has endured dramatic downward movements from Apple in the last half of 2013 and then again recently in 2015. The sector and market overall would be in a better position if Apple had just performed with the market rather than strongly in the opposite direction. Apple is down 14.4% from the high of $132.75 in May of this year. It is up only 2.4% for the year. If Apple could stabilize and keep pace with the market from here on out the sector and the market would be appreciative. It is difficult for a sector to have the largest company in the market representing over 3% of the overall market as a member. Much of the industry performance will be driven by the single stock. The sector is currently at 99% of fair value.

Materials Sector: XLB


MATERIALS: is the second to the last in terms of size and represents just 3.1% of the overall market. It is currently very close to fair value at 104%. The sector was moving along nicely with the market and then in May took a steep fall declining 9%. It started the year above our forecast and now is taking a position slightly below the lower boundary. We are still confident the sector will return to within the forecast range within the next 12 months. Materials stocks includes names such as: Alcoa, Monsanto and DuPont.

Utilities Sector: XLU


UTILITIES: is the most stable and conservative sector. Known for their excellent dividend and consistent performance, utilities are showing signs of recovery. After catching up to the market through 2013 and 2014 Federal Reserve interest rate increase expectations put a damper on the dividends produced by utilities. There was a strong exodus from the sector until mid-year when the sector produced a 6.3% price return two months. This was just after a 15% drop in the previous 6 months. This type of rapid change and range is unheard of in utilities. The type of volatility is evident in the utility chart. There are several undervalued utilities at this point such as: Entergy and Exelon.

Review Summary

Energy is the dominate story in sector valuations as it has placed significant downward pressure on both stocks within the sector and in sectors related to energy. This has traditionally be a short term gyration of the market and should stabilize over the next 12 months. In spite of the softness in energy, the remaining sectors have done well with even utilities showing some spark of late. We believe the forecast for moderate improvement still stands for the remainder of 2015 and into the 2016 calendar year.