Saturday, December 10, 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                                 18150-21200
Intermediate Term Uptrend                     11613-24463
Long Term Uptrend                                  5675-20165
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2118-2462
                                    Intermediate Term Uptrend                         2000-2602
                                    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 neutral:  above estimates: weekly purchase applications, December consumer sentiment, October wholesale inventories/sales, the November Markit services PMI, the November ISM nonmanufacturing index,; below estimates: weekly mortgage applications, month to date retail chain store sales, weekly jobless claims, revised third quarter nonfarm productivity and unit labor costs, the October trade deficit; in line with estimates: October factory orders.

The primary indicators were a slight negative: third quarter nonfarm productivity and unit labor costs (-), October factory orders (0).  One more datapoint: the growth in consumer credit slowed noticeably.

            Despite the even split in the overall stats, the productivity and consumer credit numbers weigh to the negative.  Hence, I am scoring it a slightly downbeat week.  The score is now: in the last 62 weeks, twenty-one were positive, thirty-seven negative and four neutral.
Overseas, the data was mixed but other factors should have a negative impact: the problems with bailing out Monte Paschi, the British parliament’s vote to proceed with the Brexit, China’s ongoing battle to keep the yuan from declining and 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)    Russia said that it would back the OPEC production cut; but nothing official happens until next week.  Then we will see the whites of their eyes.  That said, Putin lies, everyone cheats and US frackers are said to be gearing up to increase production. I don’t see a production cut having a lasting positive impact on oil prices even if OPEC approves it,

(2)    Friday’s ECB’s announcement that it will begin tapering its bond buying program.  More monetary tightening?  Perhaps not.  It is wrapped in so many caveats, its implementation is questionable, especially in light of the fact that there are still a lot of sick puppies in the EU banking system which will likely require aid from the ECB. 

(3)    the Donald’s trade policy.  All we have so far is words.  But if he does what he says that he is going to do, it could have a negative impact on global trade which already has a problem in the form of a soaring dollar and a depreciating yuan.

In summary, this week’s US economic stats were slightly negative, 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---but we may not know that for a year.  Nevertheless, if the current Market euphoria in any way anticipates a rise in consumer and business sentiment (spending/investment), then we could see the numbers start to improve as early as next month.  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. It is still too early to say that this reflects an improving economy but the odds grow with each passing week.  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 voted down the constitutional referendum but too little fanfare.  More importantly, the primary concern of the ‘no’ vote, a potential crisis in that country’s banking system, received a much needed boost when the Italian government said that it would inject E2 billion into Monte Paschi, its weakest bank.  The problem is that how that is done because many of the obvious alternatives violate EU rules. Moreover, it has reached the point where the can can’t be kicked down the road any longer.  I think a decision likely in the very near term; and whatever it is, there are likely to be ripples.  Meanwhile, Fitch cut its outlook for Italian banks,           

[b] the European Commission fined three major banks, one of which is JP Morgan, E485 million for a Euribor rate price fixing scheme,

The point here is that while the US banks have improved their balance sheets and gotten out of more risky businesses, the global banking system in overleveraged and chocked full of nonperforming loans.

(2)   fiscal/regulatory policy.  I continue to be hopeful that this potential negative goes away, given the Donald’s campaign promises.  And indeed, looking at his cabinet nominees, policy seems to be headed in the direction of lower taxes and less regulations.  Further, one advisor said this week that Trump was not going to tear up NAFTA.  So far, so good.

Waiting for the Trump fiscal stimulus (medium):

That said, Trump went after Boeing this week over the price of the new Air Force One contract.  The question is, what does this mean?  On the negative side, it suggests that deregulation may not be a broadly positive as many seem to think.  On the other hand, it may be just a signal to all that the federal budget will be under close scrutiny for wasteful spending. All we can do now is wait and see which Donald will stand up. (must read):

(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.  

Two things to comment on here: First, in speeches this week, several FOMC members stated that the rate of monetary normalization would depend on fiscal policy; thus grasping at the notion that somehow the Fed’s policies [QE, ZIRP] have made a big difference in pulling the US out of the financial crisis.  As you know, I give the Fed credit for the work that QEI did in stabilizing the economy.  But the rest was worse than useless, doing little to benefit the economy and serving only to create one of the greatest asset mispricing and misallocation bubbles of my life time.  The aforementioned line of self-important thinking will likely mean that the Fed will stay looser even longer and make the ultimate process of asset repricing and reallocation even more painful than necessary.

This is the best critique of the failure of QE I have ever read (a must read):

Second, this week, the ECB announced that it would begin the tapering of its bond buying program.  As I said last week, I am a bit surprised in that there are potential near term funding issues in both Italy and Greece which would require ECB assistance.  To be sure, Draghi left plenty of wiggle room by including a handful of caveats that would cause the ECB to cease and desist the tightening move.  So much so that many are doubting that this really is a tapering---the same old central bank song, bulls**t and do nothing.

(4)   geopolitical risks: Not much occurred in the Middle East this week, though Trump informed the world that he was going to shake up foreign policy.  In the campaign, he had sounded a bit dovish in the sense that he wants the US less involved in regional conflicts.  On the other hand this week, he nominated three hard asses for national security positions and he poked his finger in China’s eye by taking a call from the Taiwanese president [a no no in US China policy]. 

Frankly, I am not sure what this all means; but I do feel less easy about the potential for a foreign policy crisis.

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

[a] November UK industrial production was very disappointing while November German industrial orders were excellent,

[b] November Chinese trade figures improved, its foreign exchange reserves fell for the fifth straight month and PPI and CPI were hotter than expected,

[c] revised third quarter Japanese GDP was much lower than originally reported.

Other factors bearing on that state of the global economy include:

[a] the potential difficulties with rescuing Italy’s third largest bank and the consequences of whatever occurs,

[b] the likelihood of success of the OPEC production cut {slim to none},

[c] the British parliament’s decision to proceed with Brexit {effects unknown, the political hysteria aside}.

[d] China continues to battle a declining yuan.  The importance is that its net impact is a tightening in the global money supply.

Another week of mixed stats.  In addition, the four ‘other’ factors are on balance negative.  Certainly, there is nothing to suggest anything other than a ‘muddle through’ scenario at best.

            Bottom line:  the US economic stats were slightly disappointing 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 applications fell while purchase applications rose,

(2)                                  consumer: month to date retail chain store sales grew much slower than in the prior week, weekly jobless claims fell less than consensus; December consumer sentiment was well ahead of estimates,

(3)                                  industry: the November Markit services PMI and the November ISM nonmanufacturing index were better than expected; October factory orders were in line; October wholesale inventories were off, but sales rose dramatically,

(4)                                  macroeconomic: revised third quarter productivity was lower than anticipated while unit labor costs were higher; the October trade deficit was larger than forecast.

The Market-Disciplined Investing

The indices (DJIA 19756, S&P 2259) continued their relentless upward momentum on huge volume.  Breadth strengthened and remains in grossly overbought territory.   The VIX (11.8) got whacked by 7%, remaining below its 200 day moving average (now resistance) below its 100 day moving average (now resistance) and within a short term downtrend.  It is near the lower boundaries of its intermediate term trading range (10.3) and long term trading range (9.8).  These boundaries were set back in 2006.

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 {18150-20200}, [c] in an intermediate term uptrend {11613-24463} and [d] in a long term uptrend {5675-20165}.

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 {2118-2462}, [d] in an intermediate uptrend {2000-2602} and [e] in a long term uptrend {881-2419}. 

The long Treasury (117.5) fell another 1 1/4 %, closing 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 appears that the question, ‘will it challenge the lower boundary of its short term trading range (117.3) and the lower boundary of its intermediate term trading range (115.3) or is it attempting to build a base’, is at a critical point of being answered.

GLD (110) fell, ending below its 100 day moving average (now resistance), below its 200 day moving average (now resistance), below the lower boundary of its short term downtrend and back below at a key Fibonacci level.  The question of its attempting to stabilize is closer to being answered than TLT.  There is almost no support between current price levels and the lower level of its intermediate term trading range (100).

The dollar jumped back above the upper boundary of its short term trading range (for the third time).  If it remains there through the close next Tuesday, it will reset to an uptrend.  Given its two prior failures, it needs strong follow through to be convincing near term.

Bottom line: the upside momentum continues, driven by a lot of institutional investors being underinvested and all investors being unwilling to sell until next year because of the anticipated changes in the tax code.  The result is incredible volume and very strong breadth.  Whether or not these conditions will last long enough for the indices to challenge the upper boundaries of their long term uptrends is the question.  If they do, I still believe that those challenges will be unsuccessful.

I had wondered out loud earlier in the week whether TLT, GLD and the dollar were attempting to stabilize after some big moves.  Yesterday, they appeared to regain momentum in the original direction (down for TLT and GLD, up for UUP).  If this continues, it suggests problems for corporate profits (higher dollar, higher interest rates) and the Market (higher interest rates)
Fundamental-A Dividend Growth Investment Strategy

The DJIA (19756) finished this week about 55.5% above Fair Value (12700) while the S&P (2259) closed 43.8% 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 negative 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.  

Speaking of which, you would think that as time passed, we would receive more information and begin to develop a better sense of what the economy will look like a year from now.  We know, of course, what the Donald/GOP promised in the campaign; most of which is a plus for the economy.  But since the election, Trump has gotten involved with the operations of both Carrier and Boeing, suggesting that deregulation may not be as encompassing as many assumed.  In addition, while he was critical of foreign involvements (a plus in my opinion) in the campaign, his national security appointments and actions toward China seem a good deal more aggressive.  The point here is not to criticize his actions/statements but to point out that they don’t reflect some of his campaign rhetoric and, therefore, rather than there being more certainty with respect to the policies of a Trump administration, there is less. 

The Market could apparently care less about this at the moment and is ignoring the potential for Market moving surprises in the near future.  While I doubt that this willful disregard will last, there is still the problem of quantifying the uncertainty surrounding these elements of change---which is clearly 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 what deregulation means as well as the outcome of altered trade relations and a big increase in deficit spending.  So while I wait for clarity in order to attempt to quantify these changes, I have to settle for a qualitative statement that I believe that the net effect will be positive. 

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,

(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.

                As a long term investor, I would use the current price strength to sell a portion of your winners and all of your losers.  If I were a trader, I would consider buying a Market ETF (VIG, VYM), using a very tight stop.
DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 12/31/16                                12700            1570
Close this week                                               19756            2259

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
            55%overvalued                                   19685              2433
            60%overvalued                                   20320              2512

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.

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