Saturday, December 17, 2016

The Closing Bell

The Closing Bell


We leave for our daughter’s home on Monday and will be there through Christmas; then we go to the beach for New Year’s.  We don’t get back until 1/3.  As always, I will have my computer with me and will be in touch if necessary.  Hope all have a Happy Holiday.

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                                 18224-21274
Intermediate Term Uptrend                     11627-24477
Long Term Uptrend                                  5720-20271
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2127-2471
                                    Intermediate Term Uptrend                         2006-2608
                                    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.   Overall this week’s data was positive:  above estimates: the December housing market index, month to date retail chain store sales, November small business optimism index, the December Philly Fed business outlook survey, the December NY Fed manufacturing survey, the December Markit flash manufacturing index, October business inventories and sales, third quarter trade deficit; below estimates: November housing starts and building permits, weekly mortgage and purchase applications, November retail sales, November industrial production, the November budget deficit, November PPI; in line with estimates: weekly jobless claims, November import/export prices, November CPI.

However the primary indicators were all negative: November retail sales (-), November industrial production (-) and November housing starts and building permits    (-).   If these indicators had been mixed or if there had only been one poor number, I would have scored this a positive week; but that is not what happened.  This week was negative.  The score is now: in the last 63 weeks, twenty-one were positive, thirty-eight negative and four neutral.

            Is there more slack in the economy than is generally perceived? (medium):

Overseas, the data was positive but other factors continue to exert a negative influence over my outlook: the problems with bailing out Monte Paschi, the British parliament’s vote to proceed with the Brexit, Greece’s bailout difficulties and 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)    data this week suggest that OPEC members are already cheating before the ink on the production cut agreement is dry on the page.  Clearly that only supports my thought that the production cut agreement won’t have a lasting positive impact on oil prices,

(2)    the Bank of Japan joined the ECB in talking out of both side of its mouth, hinting early in the week that a tightening in monetary policy was coming, then jacking up its bond buying program later in the week.  On the other hand, the Fed turned a bit more hawkish than many had expected.  If this divergence in central bank monetary policies continues, it likely means a continuing rise in the dollar which will not be helpful to our trade balance or earnings of corporations with a large international exposure,

(3)    on a related item, 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.  Speaking of which, the yuan took another shellacking this week and the drawdown of China’s currency reserves continues.

In summary, this week’s US economic stats were 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. 

That said, the recent trend back to negative numbers is a little concerning in the sense that the economy may be weaker (than it seemed to be trending two weeks ago) going into what I anticipate as a more positive fiscal/regulatory environment.  Meaning that it might take more aggressive action to overcome a weakening economy than a slowly improving one.  For the moment, I am sticking with my revised tentative 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: after a trend towards more upbeat the stats, the data turned negative a couple of weeks ago, raising (once again) the question of whether the more positive respite was just that or the sign of a real improvement in economic activity.  I don’t have the answer to that; but whatever it is, we should soon start to see any impact that an upturn in sentiment might have---assuming that there is one.  So by the time we get the February economic data we should know how the economy if behaving, ex a new fiscal/regulatory agenda.   But at that point we should have some feel as to the shape of the new policies and how rapidly they will take effect.  In the meantime, Market euphoria notwithstanding, we are stuck in a period in which the economic uncertainties are higher than usual. 

To be clear, that shouldn’t be interpreted as a negative necessarily.  The economy could, indeed, be turning and sentiment could by itself stimulate business investment and consumer spending.  All I am saying is that, at the moment, it is not clear to me how the economy is trending and no one knows the impact a pickup in sentiment will have.

The problems of an irresponsible monetary policy and global economic weakness remain.
       The negatives:

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

[a] the ECB rejected a request from Monte Paschi for more time to arrange private financing; however, the Italian treasury said that it would help with the recap.  The problem, as I noted last week, is that how that is done; because many of the obvious alternatives violate EU rules.  In addition, Italy’s largest bank said in would lay off 14,000 workers and raise E13 billion                     in new capital.  And last but not least, Moody’s cut its outlook for Italian banks to negative,

[b] Wells Fargo failed a key financial test for the second time,

[c] the Eurozone financial minsters refused to approve the third Greek bailout payment.

[d] importantly, this week the Fed issued new capital requirements for the large US banks which will further improve their solvency and liquidity.

The point here is that while the US banks, the aforementioned Wells Fargo news notwithstanding, have and will continue to improve their balance sheets, 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. 

However, this week, Mitch McConnell indicated that any measure that would increase the budget deficit was a non-starter.  It is likely that this is just an initial negotiating position.  But it still indicates that any tax cut or increased spending legislation may not speed its way through congress.  In addition, those aforementioned cabinet nominees are facing opposition, which may require Trump to spend political capital to get them approved [i.e. I will vote for him Mr. President, but I need or I can’t go along with……….you fill in the blank].

The government’s interest rate payments is one of the big things McConnell is worried about (medium):

There is also the issue of trade policy which could potentially lead to disruptions and higher prices.  For the moment, all we have is rhetoric; but it could prove to be troublesome.

(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.  

As you know, this week the Fed raised the Fed Funds rate by a quarter of point---which, in my opinion, falls under the category of ‘a day late and a dollar short’.  In addition, the narrative in the press release as well as Yellen’s post meeting news conference were a bit more hawkish [three instead of two rate hikes in 2017] than had been expected.  The $64,000 question, is this really the start of the tightening process?  Remember last December, the Fed said that there would be four rate hikes in 2016; and look how that turned out. 

And speaking of wusses, early this week, the Bank of Japan made noises that suggested a coming tightening in monetary policy.  That was followed by an increase in its bond buying program.  Sort of a repeat of last week’s ECB head fake on its ‘tapering’ initiative.

The point here is that global central banks’ monetary policy is starting to diverge---which will initially be a problem for the US [i.e. its impact on trade and corporate profits]. But sooner or later it becomes a problem for everybody if foreign investors flock to dollar strength [forcing their countries’ central banks to tighten monetary policy in order to keep their currency stable and prevent the outflow of reserves].

That said, I could be getting ahead of myself in that this Fed has been, is and forever will be more dovish than its rhetoric.  So this latest move may just be a flash in the pan.

(4)   geopolitical risks: The Syrian conflict seems to be winding down [the US again losing] and being replaced by [a] the US/China sparring match, [b] the brouhaha over whether Russia interfered in the US elections and [c] the Donald’s selection for Secretary of State.  As I said last week, I feel less comfortable about the geopolitical risks now than before Trump’s actions of the last two weeks. 

Re: the US/China sparring match (medium):

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

[a]  the December EU flash manufacturing PMI was stronger than anticipated while the services PMI was weaker; November UK inflation was higher than forecast; November UK employment fell,

[b] November Chinese retail sales and industrial output were above expectations while fixed asset investment was in line; although a Chinese official said that the reported data contained a lot of fake numbers,

[c] November Japanese business sentiment rose for the first time in 18 months.

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] OK, I was wrong on the likelihood of success of the OPEC production cuts; however, the hard part {following the agreement} lies ahead.  Making matters a bit tougher, China announced that it was ramping up oil production by the most in three years.  Plus there are already signs of cheating {Iraq},

And the US rig count is surging (short):

[c] the EU finance ministers refused to approve the next portion of the Greek bailout,

[d] China continues to have difficulties stabilizing the yuan.  This week it continued to fall.  Plus, the government couldn’t attract enough investors to its latest treasury auction to complete it---meaning investors are shy of the yuan, suggesting further declines.  That is not helpful to all its trading competitors.

This week’s data was upbeat, keeping the streak of mixed or upbeat readings intact.  This has gone on long enough to suggest that the global economy may be stabilizing---not improving, just not deteriorating.  But to be sure, that in itself is an improvement.  However, when coupled with the potential economic/financial problems in Italy, Greece, China and the UK, I am not persuaded to change my ‘muddle through’ scenario; though to be fair, six weeks ago I was afraid that I was going to have to revise it to a more negative outlook.

            Bottom line:  the US economic stats were slightly disappointing this week, while the global economic numbers were somewhat better.   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 2017, which offers promise of not only better data but a normalization of Fed monetary policy. 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.  On the other hand, global trade may become an issue as the dollar rises, the yuan weakens and the Donald gets tough with our trading partners.

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: the December housing market index was upbeat; November housing starts and building permits were very disappointing; weekly mortgage and purchase applications fell,

(2)                                  consumer: November retail sales were weak relative to projections; month to date retail chain store sales grew more than in the prior week; weekly jobless claims fell slightly more than estimates,

(3)                                  industry: November industrial production was well below expectations; November small business optimism was stronger than expected; the December Philadelphia business outlook survey was ahead of forecast as were the December NY Fed manufacturing survey and the December Markit flash manufacturing index; October business inventories fell but largely due to an increase in sales,

(4)                                  macroeconomic: the November budget deficit was considerably higher than anticipated; third quarter trade deficit was less than projections; November import prices fell less than consensus while export prices were down more; both the November headline and ex food and energy PPI’s were up more than estimates, while CPI was in line.

The Market-Disciplined Investing

Yesterday, the indices (DJIA 19843, S&P 2258) inched lower; but on a quad witching and pension rebalancing day, this move was meaningless, indicative of nothing.  Volume was enormous, but again that was partly a function of option expirations.  Breadth weakened slightly.   The VIX (12.2) fell 4 ½ %, closing below its 200 day moving average (now resistance), below its 100 day moving average (now resistance) and within a short term downtrend.  The lower boundaries of its intermediate term trading range (10.3) and long term trading range (9.8) are close by---both of which 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 {18224-20274}, [c] in an intermediate term uptrend {11627-24477} and [d] in a long term uptrend {5720-20271}.

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 {2127-2471}, [d] in an intermediate uptrend {2006-2608} and [e] in a long term uptrend {881-2419}. 

The long Treasury (117.1) fell fractionally, ending 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.  In addition, it closed right on the lower boundary of its short term trading range (for a second time), clearly a set up for another challenge.

GLD (108) recovered somewhat, finishing 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 below a key Fibonacci level.  There is not much stopping it from going to the lower boundary of its intermediate term trading range (100.0).

The dollar slipped, but closed above the upper boundary of its short term trading range (for the fourth time) and for the third day.  I am going to follow my own rule and reset the short term trend to up but with the caveat that given the back and forth of recent weeks, this isn’t as solid a reset as normal.  On the other hand, lending some strength to this call is that UUP also ended above the upper boundary of its intermediate term trading range of the second day; if it remains there through the close next Tuesday, it will reset to an uptrend.

Bottom line: throw Friday’s pin action in the trash can---it was largely a function of option expirations and pension rebalancing.  That leaves us with a Market that is on a sizz propelled by investor assumptions that everything will come up roses and that staged one of the weakest consolidations from an extreme overbought condition that I have seen.  So my assumption remains that the Averages will surmount the 20000/2300 levels near term and could challenge of the upper boundaries of their long term uptrends.

UUP is challenging two major trading ranges.  If those are broken to the upside, there should be a strong follow though---that is not good for our trade balance or corporate earnings of US internationals.  The TLT is making its second stab at going lower (higher rates).  If that is successful, then it adds upward pressure on the dollar, contributes another negative to corporate earnings and cash flow and creates some cognitive dissonance to many Street valuation models.  If a higher dollar and higher interest rates occur, it will likely only make life more miserable for the gold bulls.


Fundamental-A Dividend Growth Investment Strategy

The DJIA (19843) finished this week about 56.2% above Fair Value (12700) while the S&P (2258) 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 it still reflects 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 upbeat.  But they are both secondary considerations as we try to figure out what a Trump presidency/GOP sweep means for the economy, trade and the Markets.  

Unfortunately, the Market euphoria notwithstanding, we really have no better idea about what is coming than we ever did.  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.  His, as yet to be revealed, fiscal policy (cut taxes, increase spending) is getting push back from senate leader McConnell. And problems with Trump’s more aggressive stated trade policy are likely to be exacerbated by a rising dollar and falling yuan. 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. 

In addition, the Fed’s recently stated new more hawkish stance on monetary policy could create problems.  On the economic side, higher interest rates have a lifting effect on the dollar, which in turn (1) makes any attempts by Trump revise trade agreements all the more difficult, (2) penalizes corporate profits [higher interest costs] and (3) hurts the foreign profits reported by our large international companies.  The latter two make stocks less attractive on a valuation basis.  Indeed, I linked to several articles this week that suggested the interest rates were about to start having an impact.

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.  In addition, there are the problems of the effects of rising interest rates and an appreciating dollar on the economy and corporate profits.  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.’

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, aggravated by a rising dollar and rising interest rates.  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                                               19843            2258

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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