Saturday, November 12, 2016

The Closing Bell

The Closing Bell


Statistical Summary

   Current Economic Forecast
            2015 estimates

Real Growth in Gross Domestic Product (revised)      -1.0-+2.0%
                        Inflation (revised)                                                          1.0-2.0%
                        Corporate Profits (revised)                                            -7-+5%

2016 estimates

Real Growth in Gross Domestic Product                     -1.25-+0.5%
                        Inflation (revised)                                                          0.5-1.5%
                        Corporate Profits (revised)                                            -15-0%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      17092-18693 (?)
Intermediate Term Uptrend                     11544-24394
Long Term Uptrend                                  5541-19431
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range                          1995-2103
                                    Intermediate Term Uptrend                         1981-2583
                                    Long Term Uptrend                                     862-2400
                        2015   Year End Fair Value                                      1515-1535
2016 Year End Fair Value                                      1560-1580          

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          55%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        55%

The Trump economy will likely provide am upward bias to equity valuations.   This week was about as slow as it could get, at least as it applies to the US dataflow.  Nevertheless, while it consisted entirely of secondary indicators, the bulk of the data was positive:  above estimates: weekly purchase applications, month to date retail chain store sales, weekly jobless claims, preliminary November consumer sentiment, the October small business optimism index, September wholesale sales; below estimates: weekly mortgage applications, September wholesale inventories; in line with estimates: none.

There were no primary indicators released; so the net here is a lot of secondary indicators mostly positive with no big numbers.  I am going to score this as a plus but caution that the informational value of this week’s stats is quite low. This week the score is: in the last 58 weeks, eighteen were positive, thirty-six negative and four neutral.

Overseas, the data turned negative, ending a month or so run of mixed to upbeat numbers.  So they did little to help our global ‘muddle through’ scenario.

Other factors figuring into the global outlook:

(1)    the hope for an OPEC production cut continues to fade as Saudi Arabia and Iran squared off in last weekend’s meeting.  And as a reminder: ‘….it would clearly be a positive if (1) it is actually enacted…., (2) there is no cheating and (3) the non OPEC don’t spoil the party by jacking up production to fill the gap and (4) demand doesn’t fall due to declining global economic activity.’

(2)    the solvency of Deutschebank.  No news this week, though the potential exists that the revolt against the establishment symbolized by the Brexit and Trump’s election could spell trouble for the bailout of overleveraged banks with too many bad loans and too many speculative investments.

(3)    China’s currency continued to decline.  This may be good for the Chinese economy but not so much for the rest of the world; and given Trump’s prior statements regarding Chinese trade policies, this is apt to become a much more pronounced point of friction.

Finally, on the monetary front, there was little news this week.  However, given Trump’s fiscal agenda and its very positive reception by the Market, I now believe that the Fed will raise rates in December, barring some catastrophic exogenous event.

In summary, this week’s US economic stats hardly moved the needle on the economy’s direction while the global numbers returned to their negative long term trend.  That said, if the Trump fiscal agenda is enacted, I will almost certainly revise up our 2017 economic forecast and quite possibly the long term secular economic growth rate in our Models.

  Meanwhile, there was little news out of the central banks, though I think that the Trump victory raises the odds of the December rate hike well above 50/50.  As you know, I am a big supporter of such a move though I caution that a move towards a normalized monetary policy is also a move toward undoing the mispricing and misallocation of assets.

Our forecast:

Given the likely changes coming in fiscal policy and the probable impact of those changes, some revision in our forecast will be needed.  Assuming that tax rates will be lowered and simplified, they will almost certainly provide a lift to economic growth.  A vastly reformed regulatory regime should also provide a boost.  Ditto the reform of Obamacare.  Increased spending poses more of a problem.  Little doubt that it initially will stimulate economic activity.  Longer term, however, its effect on interest rates, especially if the Fed starts normalizing monetary policy could be deleterious.  All that said, it is way too soon to start quantifying all this.  So I am going to make a qualitative change (i.e. an improving economy) and wait to see exactly what is enacted before putting any numbers on it.

On the other hand, the issue of a woefully misguided monetary policy will not be helped.  Indeed, it is apt to get worse as the Fed (hopefully) will begin the process of normalization.  That means the start of the unwinding of asset mispricing and misallocation.  While no one knows exactly how this will look, I am assuming that while it will have little impact on the economy (because QE/ZIRP never really helped) it will almost certainly involved the reversal of the asset pricing euphoria that accompanied it.

In addition, I am unsure just how revised trade agreements, a stronger dollar and higher interest rates will play out in the global economy.  Certainly the initial impact on the emerging markets has not been positive.  In addition, there is the issue of rising international populism as exemplified by Brexit and the Trump victory.  This movement, if strengthen by these two votes, could spell real problems for the EU and its heavily leveraged banking system.

Bottom line: the economy is apt to show increased growth, I have no idea how much until we see exactly what is enacted; but the problems of an irresponsible monetary policy and global economic weakness have not been helped.
       The negatives:

(1)   a vulnerable global banking system.  There was very little news on this factor this week.  However, as I noted above the Brexit/Trump combo may not portend good news for the weak EU banking system.

(2)   fiscal/regulatory policy.  Clearly, times they are a ‘changing. It certainly is too soon to be making predictions on the outcomes of a Trump presidency.  However, there are a number of factors, mostly positive, to be watching that will tell us how a potentially new fiscal policy will impact the economy.  Some of the following is repetitious of this week’s Morning Calls; but it will serve to consolidate in a more coherent pattern many of my comments.

[a] if Trump does ‘what he said he would do’ with respect to economic policy, then his election will almost certainly have an initial ‘positive impact’.  Among those measures: lower taxes and simplify the tax code, repeal Obamacare, reverse a burdensome regulatory environment, repatriating trillions of dollars held overseas by US corporations.  I stress ‘what he said he would do’ because the rubber has yet to meet the road; though to be fair the odds of enactment seem quite high,

[b] however, some of his policies have negative economic implications.  First, one of the things he said that he would do was revamp the US trade policy.  While short on details, too hard a line on trade would only exacerbate global economic weakness {I refer you to the turmoil in the emerging markets occurring as we speak.}  He has also said he wants to raise spending {while also cutting taxes}, i.e. increase the deficit and national debt.  This on top of the trillions frittered away by Bush and Obama.  This will only push the US to the brink theorized by Reinhart/Rogoff in which too much debt inhibits growth---like we need that.

[c] while it was all hugs and kisses initially as Ryan, Clinton, McConnell, Obama and Trump himself pledged cooperation, nothing has happened so far but talk.  Let’s not forget that Trump has vowed to put Hillary in jail and the republican house to commence numerous investigation of her alleged wrongdoings.  How long do you think this big pot of love stew is going to simmer in that atmosphere?  Furthermore, if you haven’t checked the news lately, Hillary’s supporters aren’t being quite as gracious as she was, as riots have broken out all across the US.

Here is a review from a former Carter staffer on Trump’s task of controlling the federal bureaucracy (medium):

[d] don’t get me wrong, strictly from the economic point of view, Trump was by far the better choice and I have little doubt that measures will be enacted that should stimulate the economy.  I am simply pointing out that it may not be as easy as many think and there are consequences to these actions not all of which are positive.              

[e] finally, I have said numerous times in these notes that political gridlock has always been my preference for governance.  It remains so; and the GOP sweep is the potential bad news segment of these comments.  The last time a GOP president had a compliant congress {Bush 2}, they loaded the budget with pork.  Granted, Trump and congress are not exactly on the same page; plus republicans have professed to have found fiscal religion.  But I am a bit hesitant to proclaim budgetary Nirvana.

Nothing has changed---yet (medium):

(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.  

This week, the central banks stayed under cover.  However, again under the category of ‘times they are a ‘changing’, the Trump presidency is apt to bring changes in monetary policy.  Most important is that an invigorated fiscal policy will relieve the pressure on the Fed of assuming that it has to carry the load of economic stimulation; in other words, it can began to normalize monetary policy.  I don’t have to tell you how happy I am about that---assuming that the Fed has the balls to actually do it.

{i} however if it does, then the whole QE/ZIRP misguided effort that led to the gross mispricing and misallocation of assets will end.
I remind you that all those mispriced assets will have to be repriced and all of those misallocated assets will have to be reallocated (scraped).  I have no idea of what the ‘price to be paid’ is because this kind of thing has never happened before.  However, not to be repetitious, I am assuming that the economic impact will be small, since QE/ZIRP did little to promote growth.  But because they did have an enormous effect on equity prices, I am assuming that their absence will have an equal but deleterious impact.

{ii} if it doesn’t and attempts to assist the financing of a mounting deficit, then that should accelerate the rise in inflation that will likely occur anyway as a result of tax cuts and increased spending.  I know that many (Keynesians) believe a little inflation is a great thing for the economy.  And maybe it is; I am not going to argue the point.  But the Fed has proven time and time again that it can’t manage a little inflation and there is no reason to assume that it will in the future.

Hence, this would only add to my recently expressed concern about rising inflation and a shrinking money supply [down again this week]. 

My bottom line is that [a] short term, given Trump’s proposed fiscal policy along with its enthusiastic reception by the Market, I now believe that the Fed will raise rates in December, [b] but long term, the risk is starting to shift toward rising inflation.

(4)   geopolitical risks: Syria is getting worse; but I think that a Trump presidency lessens the odds of any kind of US/Russian conflict.  He has criticized the international adventurism of the Bush/Obama administrations; so we should have less of that---which in my opinion is good for the economy and good for the youth of this country who have had to bear the weight of the last 16 years of neocon driven foreign policy.

(5)   economic difficulties in Europe and around the globe.  This week:

[a] October EU corporate profits declined, German industrial output fell but UK factory output rose,

[b] the October Chinese exports declined while PPI was hotter than anticipated.

Like the US, not much data.  Unlike the US, it was mostly downbeat.  So not helping our global ‘muddle through’ scenario.  Again, back to the subject of Trump.  If he pushes toward less free trade, this will hurt not only the US but the rest of the world.   It is way too soon to be making judgments about what this could mean; but again it is has to be watched as a potential sign of more falling global economic activity.

OPEC and its on again, off again production cut got lost in the news shuffle this week; although the Saudi’s and Iranian did manage to disagree publicly on quotas.  In addition, the Saudi’s released a study forecasting lower prices for longer.

‘Even if OPEC is successful in achieving an agreement, the hard part still lies ahead, because [a] there has been no allocation as yet as who has to absorb the cut and by how much, [b] OPEC members have a history of cheating’ and [c] there are a lot of non-OPEC producers in the world that will more than likely jack up production to fill the gap.’
A last observation: the Trump victory on top of the Brexit vote has a lot of the anti-EU parties in member states very excited.  I have no idea if this will lead to anything.  But assuming the British and American electorates fairly represent those in the EU, then the eurozone could be facing some very difficult political as well as economically disruptive times.

            Bottom line:  the US economy continued weak not helped by the global economic numbers.   Nevertheless, if the stars align, the US will be getting an injection of fiscal stimulus in early 2017, which offers promise of not only better data but a normalization of Fed monetary policy (and a December rate hike).

A counterproductive central bank monetary policy is the biggest economic risk to our forecast; although, it is still unclear how much fiscal stimulus will be forthcoming. 

This week’s data:

(1)                                  housing: weekly mortgage applications were down but purchase applications were up,

(2)                                  consumer: month to date retail chain store sales growth was up slightly versus the prior week; weekly jobless claims declined more than estimates; preliminary November consumer sentiment was up nicely,

(3)                                  industry: the October small business optimism was better than expected; September wholesale inventories rose less than consensus but sales were better,

(4)                                  macroeconomic: none.

The Market-Disciplined Investing

The indices (DJIA 18847, S&P 2164) had another mixed day of sort---Dow up huge, S&P down.  But it was much less volatile than earlier in the week and volume declined.  Breadth improved some more, pushing it further into overbought territory. So a correction near term should be expected.  The VIX fell, closing below its 100 day moving average, for the third day, reverting to resistance, below its 200 day moving average (now support; if it remains there through the close on Wednesday, it will revert to resistance).  However, it remains in a very short term uptrend.  If that trend holds, then stocks will likely have seen their best days.

The Dow ended [a] above on its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] above the upper boundary of its short term trading range for the second day {17092-18693; if it remains there through the close on Monday, it will reset to an uptrend}, [c] in an intermediate term uptrend {11544-24389} and [d] in a long term uptrend {5541-19431}.

The S&P finished [a] above its 100 day moving average for the third day, reverting to support, [b] above its 200 day moving average, now support, [c] within a short term trading range {1995-2193}, [d] in an intermediate uptrend {1981-2583} and [e] in a long term uptrend {862-2400}.  However, it still has a way to go before it challenges its all-time high.

The long Treasury kept diving on huge volume, closing below its 100 day moving average (now resistance), below its 200 day moving average (now resistance), below a key Fibonacci level, in a developing a very short term downtrend and below the lower boundary of its short term uptrend for a third day, resetting to a trading range and below the lower boundary of its intermediate term uptrend for a third day (if it remains there through the close next Monday, it will reset to a trading range).

GLD got pounded again (down 2 ½%), finishing below its 100 day moving average (now resistance), below its 200 day moving average for the fourth day, reverting to resistance and in a short term downtrend.  This chart continues to deteriorate.

Bottom line: the upside momentum of the Averages slowed on Friday; but given how overbought they are, that is not surprising.  Neither would a period of consolidation. The Dow is one day away from resetting to a short term uptrend.  But the S&P still has a ways to go; so Monday we may be in a situation where their pin action is divergent.  At that point, the technical picture gets even murkier than normal and we just have to wait for one or the other to confirm an overall trend. 

Meanwhile, bonds and gold are getting beaten to a pulp.  The pin action in bonds is a bit concerning because the worse it gets, the more impactful it will be on the equity discount factor.
Fundamental-A Dividend Growth Investment Strategy

The DJIA (18847) finished this week about 48.7% above Fair Value (12672) while the S&P (2164) closed 38.1% overvalued (1566).  ‘Fair Value’ will likely be changing based on a new fiscal policy which will lead to an improvement in the historically low long term secular growth rate of the economy but will still reflect the elements of a botched Fed transition from easy to tight money and a ‘muddle through’ scenario in Europe, Japan and China.

This week’s US economic data was sparse but positive while the global stats were very lousy.  But they are both secondary considerations as we try to figure out what a Trump presidency/GOP sweep means for the Markets.  As we all know, Tuesday night’s fright fest aside, the initial reaction in the stock market has been very upbeat.  While I agree with the notion that most of the economic proposals the Donald has made would be good for the economy (see above), we don’t invest in the economy, we invest in the Markets.  So here are my problems (again some of this is bit repetitious, but it consolidates a week’s worth in daily posts):

(1)   first of all, as I noted above, not all of the Trump economic proposals will likely have a positive impact.  I mentioned his statements on trade as well as cutting taxes/raising spending as examples.  Now we have no idea what will get implemented and what won’t---either the positives or the negatives.  But the point is that for the Market to seemingly only be focused on the good things is a bit short sighted.

(2)   the above caveat aside, I am acknowledge that the sum total of Trump’s proposals, if put in place, would likely improve growth and corporate profitability.  The latter raising the ‘E’ portion of the P/E valuation.  However,

[a] the current assumptions in our Valuation Model are for a better secular economic and corporate profit growth rate than has actually occurred. So any pickup in the ‘E’ of P/E is at least partially reflected already in our Year Fair Values.  In other words, our current Fair Values already incorporate a higher ‘E’.  So while it may influence others valuation, it will impact ours less---said differently, current Street Valuations require a substantial improvement in earnings just validate those Valuations.

[b] remember that in the last four years, corporate management has milked its balance sheet of every nickel in order to push earnings higher {i.e. stock buybacks financed by cheap debt, declining fixed investments, reducing labor costs}.  If the economy is going to start growing then all those accounting ploys are going to be reversed; in other words, they will put downward pressure on earnings growth.  So profits per share {‘E’} may grow but not as robustly as many may be assuming,

[c] another of the likely consequences of the Trump fiscal revolution is upward pressure on interest rates not just from higher government financing needs but from a Fed that will {should} be normalizing monetary policy.  That will have two consequences {i} with corporate America more leverage than ever, increased interest costs will have an adverse effect on earnings and {ii} higher interest rates lower the rate at which earnings growth gets discounted (the P/E).  The point is that while I agree that corporate profits may improve, perhaps it won’t be as much as many hope and the P/E being applied to those better earnings will be lower.

            The problem higher rates pose (medium):

[d] finally, the Market’s problem right now is not growth, it is the absence of real price discovery, i.e. asset mispricing and misallocation, brought on by a totally irresponsible monetary policy. One of the major things a stronger fiscal policy will do is allow the Fed to normalize monetary policy, i.e. raise rates and sell the trillions of dollars of bonds on its balance sheet. Plus if that fiscal policy reignites inflation, it will only push the Fed harder and that, in turn should reintroduce price discovery.  Once real price discovery returns to the bond markets, stocks are not likely far behind.

To be clear, normally, in an improving economy, stock prices and bond yields can rise together.  So on the surface there is nothing unusual or sinister in this pin action.  But these are not normal times.  Price discovery in the fixed income market has been distorted by QE, ZIRP etc.; and Trump has made it clear that he views that as a negative.  So if monetary policy is headed for normalization and the Fed gets out of the way of interest rate price discovery, I am assuming a reversal of asset mispricing and misallocation. This has been a potential negative that I have emphasized continuously over the last four years. 
(3)   as I mentioned above, the Trump victory in combination with the Brexit vote could lead to further tensions within the EU and possibly lead to its serious fracturing---something that would not be good for global growth or many of the highly leveraged financial institutions.

Net, net, my biggest concern for the Market is the unwinding of the gross mispricing and misallocation of assets caused by the Fed’s wildly unsuccessful, experimental QE policy.  In addition, while I am positive about the potential changes coming in fiscal/regulatory policy, I caution investors not to get too jiggy with the accompanying acceleration in economic growth and corporate profitability until we have a better idea of what and how new policies will be implemented.

‘Just to be clear where I stand: Trump’s proposed economic agenda will have a positive impact on the economy.  I will almost assuredly revise our 2017 forecast up.  I might even have to revise the long term secular economic growth rate assumption in our Models.  And that in turn would shift up our Fair Value calculations for the Averages and individual stocks.  The problem is, even if I did all of that, current Market valuations are still way too high largely as a result of central bank malfeasance.  My thesis has been and remains that once that malfeasance is corrected, equities will get repriced---down’.

Bottom line: the assumptions in our Economic Model are likely changing.  They may very well improve as we learn about the new fiscal policies and their magnitude.  However, unless they lead to explosive growth, then Street models will undoubtedly remain well ahead of our own which means that ultimately they will have to take their consensus Fair Value down for equities. 

The assumptions in our Valuation Model will also change if I raise our long term secular growth rate assumption.  This would, in turn, lift the ‘E’ component of Valuations; but there is an equally good probability that this could be offset by a lower discount factor brought on by higher interest rates/inflation and/or the reversal of seven years of asset mispricing and misallocation.

                I would use the current price strength to sell a portion of your winners and all of your losers.
DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 11/30/16                                12672            1566
Close this week                                               18847            2164

Over Valuation vs. 11/30 Close
              5% overvalued                                13305                1644
            10% overvalued                                13939               1722 
            15% overvalued                                14572               1800
            20% overvalued                                15206                1879   
            25% overvalued                                  15840              1957
            30% overvalued                                  16473              2035
            35% overvalued                                  17107              2114
            40% overvalued                                  17740              2192
            45% overvalued                                  18374              2270
            50% overvalued                                  19008              2349

Under Valuation vs. 11/30 Close
            5% undervalued                             12038                    1487
10%undervalued                            11404                   1409   
15%undervalued                            10771                   1331

* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term   cyclical influences.  The model is now accounting for somewhat below average secular growth for the next 3 to 5 years. 

The Portfolios and Buy Lists are up to date.

Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973.  His 47 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns, managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies.  Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the 74hard way.

1 comment:

  1. By knowing how the market has performed traders are in a better position to deal with it and also manage risk and returns effectively. Financial Advisory Services like trading tips can be useful for earning high returns.