Saturday, December 3, 2016

The Closing Bell

The Closing Bell


Statistical Summary

   Current Economic Forecast
2016 estimates

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

2017 estimates

Real Growth in Gross Domestic Product                      1.0-+2.5%
                        Inflation                                                                         1.0-2.0%
                        Corporate Profits                                                            +5-+10%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                                 18104-20164
Intermediate Term Uptrend                     11575-24425
Long Term Uptrend                                  5541-20148
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2111-2455
                                    Intermediate Term Uptrend                         1995-2597
                                    Long Term Uptrend                                     881-2419
                        2016   Year End Fair Value                                      1560-1580
2017 Year End Fair Value                                       1620-1640         

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’s data was positive:  above estimates: month to date retail chain store sales, November consumer confidence, the November ADP private payrolls report, October personal income, the November Markit manufacturing PMI, the November ISM manufacturing index, the November Chicago PMI, November Dallas Fed manufacturing index, third quarter revised GDP and corporate profits; below estimates: weekly mortgage and purchase applications, October pending home sales, weekly jobless claims, October personal spending, November light vehicle sales, November retail chain store sales and October construction spending; in line with estimates: the September Case Shiller home price index and October/November nonfarm payrolls.

The primary indicators were also a plus: October personal income (+), third quarter GDP (+), third quarter corporate profits (+), October personal spending (-), October construction spending (-) and October/November nonfarm payrolls (0).

Other indicators included: (1) the latest Fed Beige Book was not quite as upbeat as the prior edition and (2) the Atlanta Fed substantially lowered its projected fourth quarter GDP growth estimate.

            The latter two suggest an overall neutral reading for the week.  But since this accounting has always focused on specific data, I am scoring it an upbeat week.  The score is now: in the last 61 weeks, twenty-one were positive, thirty-six negative and four neutral.
We are now rounding the corner into the post Trump election period where the numbers could start to reflect what has been a dramatic rise in sentiment.  So if the stats follow sentiment, we should only see further improvement from here.  I have previously noted, in the absence of the election, the data was already showing some signs of progress; but all things being equal, it would still be too soon to alter our forecast of zero to negative growth rate in the economy.  Of course, all things are not equal.  The aforementioned improvement in psychology is likely to have some positive impact on spending and investment.  More importantly, if the GOP enacts the fiscal program that it has promised, it will almost certainly be a plus for the long term growth prospects for the economy.  Hence, the upcoming revision to our forecast.

Overseas, the data was mixed; and for better or worse, sentiment there is less upbeat than here.  The Italian referendum doesn’t help nor does a rocketing dollar nor does the potential for increased global economic turmoil due to a change in US trade policy.  So our global ‘muddle through’ forecast remains intact.

Other factors figuring into the global outlook:

(1)    the wish for an OPEC production cut was granted this week.  But there was a lot of funny business in the math of the quotas.  Plus US frackers are said to be gearing up to increase production.  And that says nothing about the rampant cheating that historically occurred within the group. 

Yeah, the price of oil may lift near term but I wouldn’t count on it holding, barring a dramatic increase in growth in the world economy.

Or will OPEC get lucky and US/Iran deal fall apart?

(2)    according to Draghi, the Italian banks hold a third of all EU nonperforming loans.  If that is not bad enough, a negative vote in this weekend’s referendum could impact the government’s ability to arrange their recapitalization which they are in desperate need of---an unhappy consequence for not just the Italian banks but potentially for other weak links in the EU financial system [Spanish, Portuguese, English and German banks]. 

(3)    China’s currency [along with a lot of others] continued to decline helped along by a soaring dollar.  This turmoil in the currency markets can potentially exacerbate trade relations [a] not only with the US, if we believe the Donald [b] but also amongst themselves.  If it continues, it will not be good for anybody and will almost assuredly negatively impact US corporate profitability.

In summary, this week’s US economic stats were upbeat, though I think that the data flow has less relevance at the moment than it will be when it starts to reflect the likely coming changes in fiscal/regulatory policies.  For the moment, I am revising our short term forecast but will wait until we see any concrete changes in the Trump/GOP fiscal agenda before altering the long term secular economic growth rate in our Models. 

Our (new and improved) forecast:

a possible pick up in the long term secular economic growth rate based on lower taxes, less government regulation and an increase in capital investment resulting from a more confident business community.  However, there are still a number of potential negative unknowns including a more restrictive trade policy, a possible dramatic increase in the federal budget deficit, a Fed with a proven record of failure and even whether or not the aforementioned tax and regulatory reforms can be enacted.   

It is important to note that this change in our forecast is all ‘on the come’ and hence made with a good deal less confidence than normal.  Nonetheless, I have made an initial attempt to quantify this amended outlook with the caveat that it will almost surely be revised.

Bottom line: the stats over the last month or so have reflected more of a mixed picture than purely a negative one. I am not saying that it reflects an improving economy but it is a possibility.  That said, the more important factors are (1) an upturn in sentiment which itself could be a spur to growth and (2) the likely net positive impact of the Trump fiscal/regulatory policies.  Unfortunately, I have no idea how much until we see exactly what is enacted.  The problems of an irresponsible monetary policy and global economic weakness remain.
       The negatives:

(1)   a vulnerable global banking system.  This week:

[a] Italians vote this weekend on a constitutional referendum that among other things has implications for their distressed banking system---a ‘no’ vote would raise concerns about a financial meltdown {the Italian banks need recapitalizing; political turmoil could slow down or even exacerbate this problem}.  To give you an idea of the size of this problem, the ECB reported this week that one third of all EU nonperforming loans were held by Italian banks.  I am not predicting a horror scenario, just its possibility---there are a lot of ‘ifs’ in the bad news scenario.  But were it to occur, it could infect the entire EU banking system.

Here is a more detailed explanation (medium):

[b] as an illustration, the Bank of England reported this week that three major banks had failed their most recent ‘stress test’,

[c] not to mention the continuing trials and tribulations at Deutschebank.  The latest:

[d] in addition, there is yet a potentially undetermined effect of the growing anti-establishment sentiment among voters, as reflected in the Trump/Brexit votes.  Any further challenge to the current EU economic structure would almost surely negatively impact its overleveraged banking system,

[e] finally, Chinese rates have been soaring of late based apparently on a shortage of dollars.  This is a liquidity issue that could have adverse effect not just on that country’s banking system but globally (medium and a must read).

(2)   fiscal/regulatory policy.  This is slowly becoming much less of a negative.  Of course, it all depends on the Donald’s follow through on the tax and regulatory policies that he has promised.  But clearly, his nominees for Treasury and Commerce forward his agenda.  If he/the GOP deliver, this factor could turn to a positive.  But we need to await the delivery to do that.  Further, there is still the issue of trade and its possible negative impact if the Donald gets as aggressive as he sounded in the campaign.

Trump and the new economic order (medium):

Closing the Obama growth gap (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.  

Again, I don’t want to be repetitious; but the bottom line is that an aggressive fiscal program will relieve the Fed of assuming that it has to carry the load of economic stimulation; in other words, it can began to normalize monetary policy.  As I have previously noted, the Fed will likely signal at least a start of the process in its December FOMC meeting [i.e. rate hike].  While I doubt a normalization of monetary policy will have much impact on the economy, I believe that it will dramatically effect asset repricing and reallocation---which are already beginning to occur in bonds ahead of any Fed change in policy.  The best thing the Fed can do is get out of the way of the Markets (i.e. don’t fight the rise in rates) and don’t f**k up a return to normalcy---a task unfortunately at which it has an abysmal record of success.

This week, the ECB suggested that its bond buying program had a terminal date, which is to say, it too intends to begin normalizing its monetary policy.  Of course, nothing is happening near term.  But I still thought it odd to make such a statement in front of the Italian referendum which could cause disruptions in the financial market and to which the ECB will almost certainly come to the rescue.  Nevertheless, long term, it says its intent is to begin tapering its bond buying program.

On the other side of the globe, the Bank of China has its hands full with a declining yuan exchange rate and a dollar funding problem allegedly the result of the strong dollar---necessitating a number of restrictions [among them tightening monetary policy] to stem the outflow of dollars.  That makes three.

Now the question becomes, can all this get done without severely disrupting the Markets?  See above for my answer.

Who benefited from the decade of negative real interest rates? (medium):

(4)   geopolitical risks: Syria is getting worse.  This week Turkey threatened to invade Syria which would clearly turn up the heat in that conflict.  On the other hand, 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] France’s third quarter GDP was in line while October consumer income and spending were ahead of estimates; November EU economic and industrial confidence were below consensus while consumer confidence and the manufacturing PMI were in line, November EU inflation rose but at a rate still  below the 2% goal, the UK manufacturing PMI was below estimates,

[b] November Chinese manufacturing and services PMI’s were better than anticipated

Another week of mixed stats; that is the third week in a row of not-so-negative data.  Hardly a sign that a bottom has been reached but it does continue to support to our global ‘muddle through’ scenario.  Unfortunately, this set of numbers are not apt to be helped by a continually rising dollar, a more restrictive Chinese monetary policy or the potential further weakening of the Eurozone’s economic/political system that could result from a negative vote in the Italian referendum.
            Bottom line:  the US economic stats were upbeat this week, while the global economic numbers were once again in no man’s land.   That said, both the US and global economies may be about to change, perhaps dramatically---which would make the current dataflow less relevant.  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). Not just that, there has been a huge increase in sentiment as a result of the foregoing which itself could propel a pickup in economic activity.   Hence, my new (tentative) forecast.

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 and purchase applications fell; the September Case Shiller home price index was in line; October pending home sales were well short of estimates,

(2)                                  consumer: October personal income was above projections while personal spending was below; month to date retail chain store sales improved from the prior week while November sales grew less than in October; November light vehicle sales were below forecast; November consumer confidence jumped markedly; November nonfarm payrolls increased more than estimates, but the October number was revised down substantially; the November ADP private payroll report was much better than anticipated; weekly jobless claims were disappointing,

(3)                                  industry: the November Markit manufacturing PMI and the November ISM manufacturing index were better than expected; October construction spending was less than projected; the November Dallas Fed manufacturing index was well ahead of estimates; the November Chicago PMI was outstanding,

(4)                                  macroeconomic: the revised estimate for third quarter GDP growth was ahead of forecasts while corporate profits improved from the prior reading.

The Market-Disciplined Investing

The indices’ (DJIA 19170, S&P 2191) pin action continued to diverge (Dow down, S&P flat).  Volume declined; breadth strengthened keeping it at very overbought levels.  The VIX fell fractionally.  While it remained below its 100 day moving average and in a short term downtrend, it closed above its 200 day moving average for the second day (if it remains there through the close on Tuesday, it will revert to support).
The Dow ended [a] above on its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] in a short term uptrend {18104-20163}, [c] in an intermediate term uptrend {11568-24418} and [d] in a long term uptrend {5541-20148}.

The S&P finished [a] above its 100 day moving average , now support, [b] above its 200 day moving average, now support, [c] within a short term uptrend {2111-2453}, [d] in an intermediate uptrend {1995-2597} and [e] in a long term uptrend {881-2419}. 

The long Treasury bounced after a couple of very poor days, but still closed below its 100 day moving average (now resistance), below its 200 day moving average (now resistance), below a key Fibonacci level and in a very short term downtrend.  It remains poised to challenge its short term trading range, with the lower boundary of its intermediate term trading range not that much further down.

GLD rose slightly, but enough to end back above the Fibonacci level it pushed through Thursday (small comfort).  Still it finished below its 100 day moving average (now resistance), below its 200 day moving average (now resistance) and below the lower boundary of its short term downtrend.  

The dollar sold off for a second day, finishing below the upper boundary of its former short term trading range (it had reset on Monday, then fell back below it Tuesday, then pushed over it on Wednesday and is now back below it), leaving the challenge of the short term trading range in question.

Bottom line: the Averages continue to their sideways consolidation from the recent post-election run up.  To date, it has been a bull’s dream (sideways action versus a sharp decline).  The only points of concern are a rallying in the VIX and the S&P has retreated below its former high, raising the question, was this recent breakout a false flag?  My current assumption is no and that a challenge of the upper boundaries of both indices long term uptrends is in our future.  

The sharp retreat in bond prices is a growing concern in that, the higher rates go, the bigger challenge they pose to stock valuations.  If TLT successfully challenges the lower boundaries of its short and intermediate term trading ranges, I think that equities will pick up a headwind.
Fundamental-A Dividend Growth Investment Strategy

The DJIA (19170) finished this week about 50.9% above Fair Value (12700) while the S&P (2191) closed 39.5% overvalued (1570).  ‘Fair Value’ will likely be changing based on a new set of fiscal/regulatory policies which will lead to an as yet undetermined 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 positive while the global stats were again mixed.  But they are both secondary considerations as we try to figure out what a Trump presidency/GOP sweep means for the economy and the Markets.

As I have repeatedly noted, with fiscal and regulatory polices likely to change, the current data means less than it otherwise would in the absence of those changes.  My problem is I just don’t know by how much change is in the cards---and that clearly is a determinant of Fair Value.  To be sure many of these shifts in policy will have a positive impact.  However, I am less sure about the outcome of altered trade relations and a big increase in deficit spending.  Nonetheless, from a qualitative point of view, I believe that the net effect will be positive. 

Not Bill Gross (medium):

That said, aside from the aforementioned uncertain economic effects, valuation continues to be a major problem because:

(1)   at this point, the Market is seemingly only  focused on the positive results,

(2)    while I think it reasonable to assume that the rate of corporate profit growth could pick up, that is not a forgone conclusion because earnings expansion will likely be hampered by the negative elements, among which are rising interest rates, rising labor costs, adverse currency translation costs, rising trade barriers and a slowdown in corporate buybacks,

(3)   the P/E at which those earnings are valued will be adversely impacted by higher interest rates---which is now happening in spades,

(4)   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 End Fair Values,

(5)   finally, the Market’s problem right now 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. In other words, start unwinding asset mispricing and misallocation.  Plus the unwinding of QE appears to be happening in China and Europe which could likely speed up the whole process.  Once real price discovery returns, I believe it will not be favorable to stock prices.’
Net, net, my biggest concern for the Market is the unwinding of the gross mispricing and misallocation of assets caused by the Fed’s (and the rest of the world’s central banks) 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 any accompanying acceleration in economic growth and corporate profitability until we have a better idea of what, when and how new policies will be implemented.

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. 

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 12/31/16                                12700            1570
Close this week                                               19170            2191

Over Valuation vs. 12/31 Close
              5% overvalued                                13335                1648
            10% overvalued                                13970               1727 
            15% overvalued                                14604               1805
            20% overvalued                                15240                1884   
            25% overvalued                                  15875              1962
            30% overvalued                                  16510              2041
            35% overvalued                                  17145              2119
            40% overvalued                                  17780              2198
            45% overvalued                                  18415              2276
            50% overvalued                                  19050              2355

Under Valuation vs. 12/31 Close
            5% undervalued                             12065                    1491
10%undervalued                            11430                   1413   
15%undervalued                            10795                   1334

* 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.

No comments:

Post a Comment