Saturday, February 4, 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                                 18655-20697
Intermediate Term Uptrend                     11740-24592
Long Term Uptrend                                  5730-20736
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2182-2525
                                    Intermediate Term Uptrend                         2038-2639
                                    Long Term Uptrend                                     881-2500
                        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 an upward bias to equity valuations.   However, this week’s data was mixed:  above estimates: December pending home sales, the January ADP private payroll report, January nonfarm payrolls, weekly jobless claims, the January Markit manufacturing PMI, the January ISM manufacturing index, the January Markit services PMI, December factory orders, fourth quarter nonfarm productivity and unit labor costs; below estimates: weekly mortgage and purchase applications, December personal income, month to date retail chain store sales, January retail chain store sales, January light vehicle sales, January consumer confidence, the January Dallas Fed manufacturing index, the January ISM nonmanufacturing index, the January Chicago PMI, December construction spending; in line with estimates: December personal spending, fourth quarter employment cost index.

The primary indicators were also mixed: December personal income (-), December construction spending (-), December personal spending (0), January nonfarm payrolls (+) and December factory orders (+).  The score: in the last 70 weeks, twenty-two were positive, forty-two negative and six neutral.

I noted previously that we should start seeing a pick up in the numbers if the improved post-election Market sentiment was going to be translated into an increase in consumer spending and capital expenditures. In that light, some might want to interpret the fact that this week’s stats were mixed versus negative as a positive.  If they are a lead into a series of upbeat datapoints, that would be true.  Right now, all we know is that they are a pause in an otherwise discouraging trend.  Time will tell.

Trump continues to pound away on his immigration and deregulation agenda.  While some of the measures could have some positive short term marginal economic effect (Keystone pipeline, limiting contract awards by agencies), most of his executive orders to date will simply change the way immigration and regulation are administered.  Although the latter may have larger positive economic/social consequences longer term. Still this phase of his presidency, in my opinion, is a positive, economically speaking. 

Trade is the other area that Trump has spent a lot of time and capital on; and while he has unquestionably shaken up the establishment by criticizing NAFTA/Mexico, Germany and the euro, nothing really concrete has been done---and that is the good news. I am not going to repeat the endless number of reasons why actually following through with his threats would be a negative for both our trading partners and ourselves.  My hope is that they are is just negotiating bluster and the final results will be much more free trade friendly.  But if he is serious, this will be a major economic negative.

The one, and by far the most significant, economic policy pledge that the Donald made has largely ignored to date: his promises on taxes and infrastructure spending.  And again, I am not going to repeat the numerous reasons why the math in implementing big tax cuts and major infrastructure spending doesn’t work. 

In short, Trump is making changes that will alter important aspects of how the government works and those policies will likely improve the way business in the US gets done.  However, on the big economic issues of trade, taxes and infrastructure spending, with what we know to date, I think it unlikely that there will be much impact on the secular growth rate of our economy.  For the moment, the economy continues to struggle and nothing has occurred that would alter that.

Overseas, the data, especially out of the EU, continued to recover.  I still believe that a couple more weeks of this kind of performance and the ‘muddle through’ scenario gets replaced by an improving economy.  That said, there are still problems out there: the Monte Paschi bailout, the Brexit, currency turmoil in China, Mexico and Turkey, the potential impact of a Trump anti- free trade agenda and Greece’s bailout difficulties.  Along those lines, this week, China reported that 2016 witnessed record capital outflows.

In summary, this week’s US economic stats were mixed which may or may not support the notions that either the economy is improving or is about to improve based on increasing investor sentiment. 

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: the US data this week was both plentiful and mixed.  While an improvement from the recent trend of lousy stats, it is hardly a sign that the economy has turned the corner.  We must wait for more information before drawing that conclusion.    In the meantime, my take is that we are in an economy (1) that isn’t making much headway, (2) in which the known Trump economic policy changes are not that encouraging [‘border’ tax; currency valuation], (3) the unknown [tax cuts and infrastructure spending] policies are not being discussed, but (4) all of which may be about to change.  In short, a very fluid environment.

Update on bug four economic indicators (medium):

       The negatives:

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

[a] Deutschebank pleaded guilty to laundering Russian money.  These guys seem to know no bounds to breaking the law,

[b] Secretary of Treasury nominee Mnuchin said that he would not permit bank proprietary trading.  The US continues to lead the rest of the world in eliminating practices that put the ‘too big to fail’ banks at risk.  However, progress in the rest of the developed world has been slim to none, leaving the global banking system vulnerable,

[c] and there is this (short and a must read):

(2)   fiscal/regulatory policy.  As you know, I have been hopeful that the Donald would eliminate this as a potential negative.  And, indeed, he has taken steps to reverse the regulatory burden that has been loaded on the economy, including executive orders barring the EPA from awarding any new contracts, freezing the implementation of last minute regulations imposed by Obamacare, advancing the construction of the Keystone and Dakota pipelines, authorizing the building of the wall on our southern border, cutting funds to sanctuary cities, the enhanced vetting of immigrants [potential terrorists] and the temporary travel ban.  In addition, his nominee for the Supreme Court will be a major plus for those of us who object to legislation from the bench.

However, on Friday Trump did produce one potential sour note in his deregulation campaign---which was the roll back of some provisions of Dodd Frank.  Just a point: Dodd Frank is law and he can’t change it with an executive order.  All he can do [and is doing] is draft proposals for congressional consideration.  So nothing is going to happen in this arena immediately.  But he has set the ball rolling.  As I read his proposals they will no doubt help the banks and their profitability; although they also seem to lift the penalties for screwing the public.  The administration is selling [and apparently the Street is buying] its proposals not as a voiding of Dodd Frank, but rather as an adjustment that corrects some of the more extreme provisions.  And that could be true; we need just need more detail before drawing any firm conclusions.

On the other hand, Trump fiscal actions have, in my opinion, been negative: muscling company or industry officials to do his bidding [just another form of regulation], talking the dollar down [currency war], getting into a pissing contest with Mexico over ‘the wall’ and Germany over the valuation of the euro and the continuing failure to address taxes and infrastructure spending [the policies that could have the largest impact on the economy].

Of course, many of Donald’s initial currency/trade positions may just be for negotiating purposes.  So the ultimate outcome could be quite positive.  However, until we know how this turns out, there is cause for unease.
With trade, there are no losers (medium and a must read):

The potential impact of the border tax on the EU (medium):

With regard to cutting taxes and instituting major infrastructure projects, I have suggested that the math of these promises simply doesn’t work.  The current level of both the federal debt and the budget deficit are too high to make such proposals economically constructive.  Sure, he can cut fat in the budget and can reverse expensive regulations implemented by prior executive orders; and those saving can be spent elsewhere.  He can rationalize the tax code, making it fairer.  But a net large tax cut and a net major increase in infrastructure spending would do more to stymy economic growth than enhance it [reference the Rogoff/Reinhart study which states that countries where debt in greater than 90% of GDP spend more resources servicing the debt than stimulating growth---see link below].  And none of this takes into consideration the congressional GOP leaders pledge to not add to the debt.  In short, I am not sure of the extent to which Trump can deliver on what were, economically speaking, his most important campaign promises.

On a potentially more positive note, on Thursday, there was an announcement published by the Japanese government stating its intent on investing in US infrastructure projects. 

        A follow up to the Japanese proposal (medium):

Finally, I think that there is an issue of style that is problematical.  I know that many love the Donald’s confrontational approach.  I do too; at least in respect to the press.  However, I am not sure name calling, personal insults and narcissistic self-praise advance the odds of getting his proposals implemented, assist in winning the support of those Americans in the middle of the political spectrum and enhance the stature of the office.

(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.  

The FOMC held a meeting this week; and its subsequent statement was notable in what was said---which was absolutely nothing.  The narrative and tone was almost exactly the same as the prior statement---with one minor exception. The verb referring to rising inflation went from ‘expected’ to ‘will’.  That hints at a slightly more hawkish stance. 

However, the odds for a rate increase [as determined by spreads in the bond market] actually declined, suggesting that the bond guys think nothing has changed.  That likely also means that they see little chance of large tax cuts and infrastructure spending, at least anytime soon, since those measures would probably put upward pressure on inflation and that would require a Fed response.

But that is just speculation at this point.  For the moment we are in a struggling economy and I have serious doubts that we will get the kind of massive tax and spending programs promised by Trump.  In which case, the central banks can continue their dovish approach to monetary policy, i.e. do nothing to correct to residual problems [i.e. asset mispricing and misallocation] created by QE, ZIRP and NIRP.

Counterpoint (medium and a must read):

Dead dove walking (medium):

Across the pond, the Bank of England left key interest rates unchanged and upgraded its economic outlook.  While the latter seems to be a continuing theme, I imagine that the BOE will be constrained by worries over the potential impact of Brexit---which is moving along.

(4)   geopolitical risks: Trump continued to stick his finger in as many foreign eyes as possible.  The primary recipient this week was the Germans, who a chief advisor accused of keeping the euro undervalued in order to exploit the US and other EU countries.  This on top of earlier comments on EU NATO members not carrying their fair share of that organizations budget.  To be sure, both are valid criticisms.  So this may be another of those ‘hard ass’ initial negotiating positions whose intent is to achieve something more modest but still accomplishes pro US objectives. 

There also rising tension between the US and Iran following the latter’s missile test that the former claims violates the Iran nuclear deal.  The administration ‘put Iran on notice’ and then immediately acted on that notice, imposing new sanctions on Iran.  Personally, I have no problem with expecting Iran to live up to the terms of the nuclear deal and taking action when it doesn’t.  But the process of making this point does increase the odds of a misstep.

And finally, it appears terrorists are coming across the southern border (medium):

My conclusion remains: I don’t think it an understatement to say that geopolitical risks are increasing.

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

[a] January EU industrial and economic confidence were above estimates while services confidence was below; 2016 EU GDP growth was up, unemployment was down and inflation up, all better than consensus; the January UK manufacturing PMI was in line,

[b] January Chinese manufacturing PMI was below estimates while the nonmanufacturing PMI was above; 2016 Chinese capital outflows hit a record high,

[c] the Bank of Japan raised its forecast for 2017 GDP growth and inflation.

[d] the Greek bailout problem is raising its head once again.

So this week’s data was another positive one.  The stats continue to improve sufficiently to suggest that the global economy may be stabilizing---enough so that another couple of weeks of better numbers will warrant a change in our forecast. Holding me back are the potential economic/financial problems in Italy, Greece, China, Mexico, Turkey and the UK.

A new problem for Mexico (medium):

            Bottom line:  the US economic stats turned mixed this week---meaning that the data is still not supporting the notion that the economy is currently improving.  That of course, doesn’t help my short term forecast that economic conditions will get better as the result of rising optimism.  In the meantime, we have precious little on fiscal/regulatory policies that could have a material long term positive impact on the economy.

Foreign economic data improved.  I just need a bit more of the same before considering any revisions to our ‘muddle through’ scenario.

This week’s data:

(1)                                  housing: December pending home sales were above projections; weekly mortgage and purchase applications were down,

(2)                                  consumer: December personal income was below estimates while personal spending was in line; the January ADP private payroll report was well ahead of expectations as was January nonfarm payrolls; weekly jobless claims were better than anticipated; month to date retail chain store sales grew slower than in the prior week, while January sales were below consensus; January light vehicle sales were less than forecast; the January consumer confidence was slightly below projections,

The Market seemed particularly enthralled with the January nonfarm payroll number.  Here is Mohamed El Erian’s take (medium):

(3)                                  industry: the January Dallas Fed manufacturing index was disappointing as was the January Chicago PMI; however, both the January Markit manufacturing PMI and the January ISM manufacturing index were better than estimates while the services PMI and ISM nonmanufacturing index was worse; December construction spending was terrible; December factory orders were well ahead of expectations,

(4)                                  macroeconomic: the fourth quarter employment cost index was below forecast; fourth quarter nonfarm productivity and unit labor costs were better than anticipated.

The Market-Disciplined Investing

The indices (DJIA 20071, S&P 2297) had a good day Friday with the Dow regaining 20000 but the S&P once again failing to mount 2300.  Volume fell but remained at elevated levels; breadth was positive.   The VIX (11.0) dropped 8%, closing below its 100 and 200 day moving averages (now resistance) and in a short term downtrend but is again nearing the lower boundary of its intermediate term trading range (10.3) which is only slightly above the lower boundary of its long term trading range (9.8).   Thus it is very close to record complacency.
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 {18655-20695}, [c] in an intermediate term uptrend {11740-24592} and [d] in a long term uptrend {5730-20736}.

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 {2182-2525}, [d] in an intermediate uptrend {2038-2639} and [e] in a long term uptrend {881-2500}.

The long Treasury declined slightly, remaining in a very short term downtrend, near the lower boundary of its short term trading range and below the 100 day moving average (now resistance), falling further below its 200 day moving average (now resistance).  

GLD (116.1) was up again and will reestablish a very short term uptrend if it finishes above 116.0 on Monday.  It is also close to challenging its 100 day moving average (now resistance).  It remained below its 200 day moving average (now resistance) and within a short term downtrend. 

The dollar declined slightly, but remains in a narrowing range bounded by the 100 day moving average (now support) on the downside and the upper boundary of its very short term downtrend on the upside.  A break above/below one of these levels will likely point to a directional move.  It is still above 200 day moving averages (now support) and in a short term uptrend.  

Bottom line: investors got jiggy Friday with the nonfarm payrolls number and Trump’s move to amend Dodd Frank.  While the Dow regained 20000, the S&P failed to move above 2300.  Until that occurs, I think the upside in stocks in general is limited. 
            TLT, UUP and GLD appear to be about to challenge the first resistance/support levels that could lead to directional changes---although rising interest rates, rising gold prices and a weak dollar are somewhat inconsistent suggesting something is amiss.  My interest is in GLD which I think would be a trade if it reestablishes a very short term uptrend and successfully challenges its 100 moving average.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (20071) finished this week about 57.0% above Fair Value (12782) while the S&P (2297) closed 45.3% overvalued (1580).  ‘Fair Value’ will likely be changing based on a new set of fiscal/regulatory policies which may 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 mixed this week.  Some may want to read that as a positive.  I think more information is needed to draw that conclusion.  However, the Market continues to interpret all data/news in a very positive light---which currently is that a major turnaround in the economy is occurring based on new pro Market regulatory/fiscal policies from the new administration. 

To be sure, Trump is moving at neck break speed issuing one executive order after another.  But those are bringing both welcome and unwelcome regulatory change to immigration, trade and the government bureaucracy.  While construction of the Keystone pipeline and the suspension of agency awarded contracts will have a positive economic impact, most of these orders will more heavily influence social/political policy. 

On the other hand, Trump’s economic actions to date have been less than positive: muscling corporations, talking down the dollar and threats of tariff.  Although, not to be repetitious, much of the dollar/tariff talk may just be initial negotiating positions on issues from which positives can be derived.  Still what we have today is negative.

In addition, all we have now is talk with respect to the major economic pillars of his campaign pledges: tax cuts and infrastructure spending.  And as I have opined throughout this narrative, he may have real problems implementing any such policies that would significantly enhance economic expansion. 

That said, the stunning announcement by the Japanese that they would invest in US infrastructure could be a God spend for Trump; though I need to remind all that the only way foreigners have dollars to invest in the US is if we run a trade deficit with them.  We can’t have it both ways.

Finally, Trump seems intent of antagonizing as many foreign leaders as possible.  The actions toward Mexico, Germany, Japan and China may again just be initial negotiating positions that could lead to changes that will favor the US.  However, an unstable international environment tends not to be good for stock prices---and that is what we are concerned with here.

This week’s international stats were upbeat, increasing the odds that I will upgrade our ‘muddle through’ forecast.  However, I am still worried about a number major problems (Brexit, currency problems, free trade issues) looming out there.

Net, net, in general, my expectations for some improvement in the economic outlook remain high (‘some’ being the operative word).  However, I am not sure how much it will impact the assumptions in our Models.  Remember, those assumptions are calculated more on long term trend basis and less on what is likely to happen the coming 12 months.  Currently, they show a higher economic growth rate than now exists; so a modest pickup in growth will not alter the assumptions.  Trump/GOP will need to up their game to have any impact on the Models.  The point being, current euphoria notwithstanding, nothing has happened yet to change our Fair Value estimates.  I would love to see policies that would.

All that being said, you know that my negative outlook for stocks has little to do with the progress or lack thereof for the economy/corporate profits and is directly related to the irresponsibly aggressive global central bank monetary policy which has led to the gross misallocation and mispricing of assets.  The Fed has $4 trillion on its balance sheet which it has no clue how to get rid of.  And Draghi just said that EU QE isn’t going away anytime soon. 

The investment problem here is that while a big pickup in economic/profit growth could have a positive impact on Fair Value in our Model, it would also push the Fed toward unwinding the bloated balance sheet and raising interest rates.  You will recall that my thesis all along has been that since the economy was little helped by QE/ZIRP, then it could do just fine in the face of a reversal of those policies.  On the other hand, since the Markets were the primary beneficiaries of Fed largesse, it would be they who suffered when the Fed began to tighten.

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 encouraged 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.  Finally, whatever happens, stocks are at or near historical extremes in valuation and there is no reason to assume that mean reversion no longer occurs.

Bottom line: the assumptions in our Economic Model may very well improve as we learn about the new fiscal/regulatory policies and their magnitude.  However, unless they lead to explosive growth, they do little to alter the assumptions in our Models.  That suggests that Street models will undoubtedly remain more optimistic than our own which means that ultimately they will have to take their consensus Fair Value down for equities. 

Our Valuation Model could 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 at least partially 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, with equity valuations at historical highs, 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 2/28/17                                  12782            1580
Close this week                                               20071            2297

Over Valuation vs. 2/28 Close
              5% overvalued                                13421                1659
            10% overvalued                                14060               1738 
            15% overvalued                                14699               1817
            20% overvalued                                15338                1896   
            25% overvalued                                  15977              1975
            30% overvalued                                  16616              2054
            35% overvalued                                  17255              2133
            40% overvalued                                  17894              2212
            45% overvalued                                  18533              2291
            50% overvalued                                  19173              2370
            55%overvalued                                   19812              2449
            60%overvalued                                   20451              2528

Under Valuation vs. 2/28 Close
            5% undervalued                             12142                    1501
10%undervalued                            11503                   1422   
15%undervalued                            10864                   1343

* 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 hard way.

No comments:

Post a Comment