Saturday, January 7, 2017

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                                 18392-21442
Intermediate Term Uptrend                     11662-24512
Long Term Uptrend                                  5730-20318
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2149-2493
                                    Intermediate Term Uptrend                         2019-2621
                                    Long Term Uptrend                                     881-2435
                        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 overwhelmingly positive:  above estimates: month to date retail chain store sales, weekly jobless claims, December light vehicle sales, November factory orders, the December Markit manufacturing PMI, the December ISM manufacturing and nonmanufacturing indices, November construction spending; below estimates: weekly mortgage and purchase applications, the December ADP private payroll report, the December Markit services PMI and the November US trade deficit; in line with estimates: November/December nonfarm payrolls.

In addition, the primary indicators were positive: November construction spending (+), November factory orders, though they were still down a lot (+) and December/November nonfarm payrolls combo (0).  The score is now: in the last 66 weeks, twenty-two were positive, forty negative and four neutral.

Overseas, the data continued to improve.  Indeed, it is time to start considering that the global economy may be stabilizing. I am not altering our ‘muddling through’ forecast, but the numbers have been good enough to begin challenging it.  However, a big constraining factor is the as yet unresolved problems stemming from the Monte Paschi bailout, the Brexit, and Greece’s bailout difficulties.  So our global ‘muddle through’ forecast remains intact.

Other factors figuring into the global outlook:

(1)    complaints are already arising about cheating [Kurdish Iraq] on the OPEC production quotas---which supports my thought that the production cut agreement won’t have a lasting positive impact on oil prices,

(2)    the Bank of China continues to have problems stabilizing the yuan.  To date, some of its countermeasures have included raising rates internally and selling US Treasuries both of which put upward pressure on global interest rates,

(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 upbeat following several negative weeks.  However, those results notwithstanding, 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 four 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. 

That said, we could start seeing some more positive data if the Trump sentiment improvement gets reflected in the numbers.  If that happens, the questions become (1) how quickly can new fiscal/regulatory policies be put in place and (2) can improved sentiment sustain any increase in economic activity long enough for those policy changes start to have an impact? 

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.   

Update on big four economic indicators.

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 data trend turned negative a month ago, raising (once again) the question of whether the prior period of more positive stats was temporary or the sign of a real improvement in economic activity.  Clearly this week’s numbers suggest the latter.  However, whatever the trend, we should soon start to see any impact that an upturn in sentiment might have---assuming that there is one.  By the time we get the February economic data we should know how the economy if behaving, ex a new fiscal/regulatory agenda.   And 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. 

The problems of monetary policy and global economic weakness remain, though this week’s international data provides some hope that this could be changing.
       The negatives:

(1)   a vulnerable global banking system.  This week a report on global debt estimated that it had reached 325% of world GDP with much of it housed in the banking system.  While that doesn’t necessarily mean a financial disaster, it does suggest that [a] the level of nonperforming debt is also growing as a percent of world GDP and [b] the ability of the financial system to fund future investment and consumer spending is being reduced.

(2)   fiscal/regulatory policy.  I continue to be hopeful that this potential negative goes away, given the Donald’s campaign promises.  This week, there were more developments that supports that notion: the senate initiating steps to repeal and replace Obamacare and Trump’s moves to do away with many immigration executive orders.  Another plus that has been below the radar is the movement through congress of the ‘Reins Act’ which will serve to restrict the issuance of executive orders by the White House.

That said, the president-elect has already gotten push back on fiscal issues from GOP senate leader McConnell and this week the chorus was joined by Speaker Ryan [no new tariffs] and senate democratic leader Schumer [no new anything].  So the questions of how soon and how dramatic the change in policies are there.

In addition, as a free market advocate, I am not happy with the [soon to be] president threatening companies that are legally pursuing the best interest of their shareholders.  If Trump wants to change the law---give it a shot.  But his actions are no different from Obama’s outrageous [and I believe unconstitutional] legislating by executive orders.

Further, free trade has been a major benefit to the US and global economies.  True, there are cheaters.  I support measures to level the playing field, but not starting a trade war.  That said, I have observed that Trump’s rhetoric may just be a negotiating position---‘may’ being the operative word.  But I worry about the enactment or imposition of any measure that restrains free trade.

(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 released the minutes of its last FOMC meeting and took the art of obfuscation to new heights.  In addition in those minutes, it cited the potential of a more aggressive fiscal policy as a risk [to inflation] after having complained for the last five years that it needed a more assertive fiscal policy to relieve the Fed of being the sole agency of economic stimulation. 

                  Fed uncertainty BINGO (medium):

Further, as I noted on Thursday, the Fed continues to shrink the money supply which is a monetary tightening move.  True, it had injected a lot of liquidity into the system which now it apparently is trying to soak up---and this may just be neutralizing maneuver.  However, focusing attention on interest rates and failing to address money supply only adds the confusion and plays to the notion that the Fed hasn’t a clue what it is doing.

Another excoriating critique of global central banks addressing the above issue from Jeffery Snider (must read):

Overseas, the Chinese are having a hell of a time stabilizing the yuan.  This has led to several dramatic policy steps including severe restrictions on capital flows.  These measure amount to tightening monetary policy.  So whether or not the Fed is drifting in that direction, there is now more upward pressure on interest rates.

Aside from the chronicling of Fed ineptness, the point here is that global central banks’ monetary policy is starting to diverge with China and the US beginning to tighten and Japan and the ECB remaining accommodative.  Sooner or later this will create trade issues for all and profit problems for US companies.

(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.’ 

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

[a] the December EU final composite PMI and CPI were stronger than expected as was the UK manufacturing and services PMI’s,

[b] the December Chinese manufacturing, services and composite PMI’s were above estimates,

[c] the December Japanese Markit manufacturing PMI was above forecast.

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] early signs of cheating on the OPEC production cut agreement,

        Rising US rig count (short):

[c] China continues to have difficulties stabilizing the yuan.  This week it continued to fall in the face of aggressive government countermeasures.  A declining yuan does not improve the outlook for the likely coming trade negotiations with the US.  In addition, Mexico is now starting to have currency valuation problems.  It is not helpful to either trade or the securities markets for two major economies to be experiencing significant currency volatility.

This week’s data was very 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. 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 just yet; 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 quite positive this week. That keeps alive the possibility that the US economy is stabilizing, though after a month of disappointing stats not by much.  Of course, this may all be irrelevant if the Trump euphoria translates in to improved numbers and then he actually delivers on all those promises. On the other hand, nothing has happened just yet; so it might be wise to be a bit circumspect for the moment.

Foreign economic data also improved significantly, though the record of improvement to date is less dramatic than even our own.  Nonetheless, I will take good news from wherever I get it.  I just need a lot more of the same before considering any revisions to our ‘muddle through’ scenario.

A counterproductive central bank monetary policy is the biggest economic risk to our forecast.  Plus, it is still unclear the extent to which the US and global economies are or will improve. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications fell,

(2)                                  consumer: month to date retail chain store sales grew more than in the prior week; December light vehicle sales were higher than anticipated; the December ADP private payroll report was disappointing as was December nonfarm payrolls, although the November number was revised significantly upward; weekly jobless claims fell more than projected,

(3)                                  industry: November factory orders were down less than consensus; the December Markit manufacturing PMI was slightly above expectations while the services PMI was below; the December ISM manufacturing and nonmanufacturing indices were ahead of forecast; November construction spending was well ahead of estimates,

(4)                                  macroeconomic: the November US trade deficit was greater than anticipated.

The Market-Disciplined Investing

Yesterday, the indices (DJIA 19963, S&P 2276) reaccelerated.  Volume was flat but is still high.  Breadth was mixed again.   The VIX (11.3) fell another 3 ¼ %, closing below its 200 day moving average (now resistance), below its 100 day moving average (now resistance), within a short term downtrend and moved closer to the lower boundary of its intermediate term trading range (10.3).  
The Dow ended [a] above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] in a short term uptrend {18392-20442}, [c] in an intermediate term uptrend {11662-24512} and [d] in a long term uptrend {5730-20318}.

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 {2149-2493}, [d] in an intermediate uptrend {2019-2621} and [e] in a long term uptrend {881-2435}. 

The long Treasury declined and ended in a very short term downtrend, in a short term trading range and below the 100 day moving average (now resistance), falling further below its 200 day moving average (now resistance).  However, it still has plenty of room to rebound before it meets any of the multiple resistance levels or threatens to break any major downtrends.

GLD continues to mimic TLT, trading off yesterday and remaining in a short term downtrend and below its 100 day moving average (now resistance) which continues to push further below its 200 day moving average (now resistance).   Also like TLT, it can recover significantly before threatening to challenge major resistance/downtrends.

The dollar rose, continuing its pattern of acting in reverse of GLD and TLT, finishing considerably above multiple support levels---so it can fall a lot and not challenge its 100 or 200 day moving averages (now support) or its short term uptrend.   

Bottom line: my assumption continues to be that the indices will at least challenge the 20000/2300 levels; and if victorious, there is no resistance between those levels and the upper boundaries of their long term uptrends.  But as you know, I don’t believe any such challenge (of the upper boundaries) will be successful.
            Despite yesterday’s minor counter trend moves, TLT, GLD and UUP still seem to be rebounding from extreme positions.  Part of this is related to the turmoil in the Chinese and Mexican currency markets, part of it seems to be function of waning optimism among the bond boys about the strength of any impact of the Trump/GOP fiscal/regulatory reforms.  Clearly the latter is in direct conflict with the giddy attitude of stock investors.  I am not saying who is right; just that there appears to be some dissention in the ranks.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (19963) finished this week about 56.6% above Fair Value (12741) while the S&P (2276) closed 44.5% overvalued (1575).  ‘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 turned positive after a month long run of disappointments.  Under normal circumstances, I would say that the overall trend supports the notion of an economy continuing to struggle to stay on the plus side of growth.  But these are not normal circumstance.  As you know, I believe that there is a reasonable likelihood that the vast improvement in business and consumer sentiment will soon start being reflected in the numbers; and I believe that this likelihood will increase dramatically if the anticipated changes in fiscal/regulatory policies are implemented.

This week’s international stats were very positive---a very unique occurrence over the past two years.  And they follow a brief period in which negative weeks have been alternating with neutral to upbeat weeks.  This timeframe is still too short to assume that the global economy has stabilized; but it is certainly a hopeful sign.

Well, says you, that must mean that you (I) are looking for higher equity valuations.   Au contraire, monsieur.  My less than positive outlook for stocks has been much less contingent on economic/corporate profit improvement and more on irresponsibly aggressive global central bank monetary policy which led to the gross misallocation and mispricing of assets.  To be sure, a pickup in economic/profit growth will have a positive impact on Fair Value in our Model.  But valuations are so distorted to the upside that this will likely prove small comfort when the mean reversion process begins. 

And that assumes that we get the fiscal/regulatory measures over which investors have become so infatuated---for which there are no guarantees.  Certainly, most of the Donald’s executive branch appointments lend credence to the notion that great positive changes are afoot.  On the other hand, I am dismayed by his attacks on corporations which made perfectly legal decisions based on the best interest of their shareholders.  That is not free enterprise and suggests that we could be trading one form of regulation for another. 

In addition, Trump’s comments on trade suggest that free trade is not high on his economic goals list.  True, these may only be initial negotiating positions; but they are nonetheless worrisome.  Free trade has been part and parcel of the US economies growth; and I dare say that in its absence the economic malaise of the last decade would have been worse.

A lesson in trade economics (medium and a must read---that means you Donald):

Further, the push back has started.  McConnell has already said expanding the budget deficit (cutting taxes and increasing spending) is a nonstarter.  Ryan has jumped in and said there will be no tariffs.  Plus, Trump has gone out of his way to piss off Chuck Schumer; and while the GOP controls both houses in congress, the last thing we need is a fist fight over every issue.

None of this even addresses the 800 pound gorilla in the room---which is the need to unwind years of the aforementioned irresponsible monetary policies, i.e. QE and ZIRP. I have no idea whether or not we are witnessing the beginning of the end in the form of the currency problems being experienced in China and Mexico.  But I will suggest that those are the kind of problems to expect when the unwinding process begins. 

Of course, the Market could apparently care less about anything negative at the moment.  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.  But everything is not coming up roses.  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 economically. 

That said, 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 about 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 2017 Year End Fair Value*              13200             1630
Fair Value as of 1/31/17                                  12741            1575
Close this week                                               19963            2276

Over Valuation vs. 1/31 Close
              5% overvalued                                13378                1653
            10% overvalued                                14015               1732 
            15% overvalued                                14652               1811
            20% overvalued                                15289                1890   
            25% overvalued                                  15926              1968
            30% overvalued                                  16563              2047
            35% overvalued                                  17200              2126
            40% overvalued                                  17837              2205
            45% overvalued                                  18474              2283
            50% overvalued                                  19111              2362
            55%overvalued                                   19748              2441
            60%overvalued                                   20385              2520

Under Valuation vs. 1/31 Close
            5% undervalued                             12103                    1496
10%undervalued                            11466                   1417   
15%undervalued                            10829                   1338

* 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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