Saturday, February 11, 2017

The Closing Bell

The Closing Bell


I have family business to attend to next Monday and Tuesday and it could run into Wednesday.  I don’t know which; but I will be back.

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                                 18742-20784
Intermediate Term Uptrend                     11758-24613
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                                     2188-2531
                                    Intermediate Term Uptrend                         2042-2643
                                    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.   While this week’s data was comprised entirely of secondary indicators, it was, nonetheless, overwhelming positive:  above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, weekly jobless claims, December consumer credit, December wholesale inventories/sales and the December trade deficit; below estimates: February consumer sentiment; in line with estimates: January import/export prices (note: I am listing this as a neutral because it depends on your perspective whether this is good or bad news.)

 The score: in the last 71 weeks, twenty-three were positive, forty-two negative and six neutral.

If you are an optimist, you would consider the last two weeks’ dataflow as a sign of a pick up in the numbers due to the improved post-election Market sentiment being translated into an increase in consumer spending and capital expenditures. I think it a bit too short of a time span to conclude that but it must be regarded as a possibility.

On the political side, Trump continues to dazzle us with his footwork.  By and large, his deregulation agenda is right on track and while it may deliver upbeat economic results long term, to date, his measures short term will not be enough to move the needle on our economic forecast.  But just to be clear, 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---and this week’s meeting with Abe, who comes bearing gifts, may be a signal that is the case.  But if he is serious, this will be a major economic negative.

Most important, this week the Donald finally addressed one of the most significant, economic policy pledges of his campaign: taxes.  However, all he really did was address it---saying simply to expect a ‘phenomenal’ plan in the next two to three weeks.  However, given the rumors from two well connected sources, there seems little doubt that he will present a ‘phenomenal’ plan.  But when he does so, he needs to tackle (1) its math as regards the budget deficit and federal debt and (2) congressional concerns about the same.  As you know, I don’t see how it can be done and not exacerbate the already huge deficit/debt problem---which has been shown to have a substantial negative impact on economic growth.  In other words, a larger deficit doesn’t solve the growth problem.  I await the plan breathlessly.

Overseas, the data this week turned sour; though this is just one week in what has been a hopeful trend of more positive numbers.  If this proves to be an aberration, then there remains a decent probability that 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. 

In summary, this week’s US economic stats were quite positive, providing minor support to the notions that either the economy is improving or is about to improve based on increasing investor sentiment.  More is needed before I consider changing our forecast.

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 very upbeat.  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] and (3) the unknown [tax cuts and infrastructure spending] policies have yet to be addressed in any meaningful way, but which may be about to change. 
The latest from Van Hoisington (medium and a must read):

       The negatives:

(1)   a vulnerable global banking system.  In what may be the best news that I have seen on this issue in some time, this week the DOJ launched a probe of individuals involved in Deutschebank’s mortgage security fraud.  I have always believed that one of the best ways of curbing corruption was hold the people involved accountable, i.e. jail time.

Here is another must read piece from Jeffrey Snider on the failures of the banking system (medium):

(2)   fiscal/regulatory policy.  I continue to hope that the Donald’s new policies will prove beneficial to the economy and I can eliminate this factor as a negative.  Certainly, the efforts to curb the power of regulatory agencies is an economic plus.  In addition, advancing the construction of the Dakota and Keystone pipelines and reforming the aviation industry’s infrastructure could be helpful; although as I noted in a link this week, it appears that the Keystone pipeline is not economically viable at current prices.  Enforcing the immigration laws could be advantageous if handled properly.  So there is lots of good news.

However, Trump’s comments on trade, which can be far more impactful than any of the above, demonstrate the seeming lack of understanding of what free trade has meant to global prosperity and peace.  And trying to talk down the dollar only generates similar responses from our trading partners, which in the end accomplishes nothing expect fostering ill will. 

To be fair, I remain open to the notion that many of Donald’s initial currency/trade positions may just be for negotiating purposes.  So the ultimate outcome could be quite positive.  The recent meetings between Tillerson and his Canadian and Mexica counterparts is a hopeful sign as was Trump’s friendly overture to China and the Japanese apparent intent on investing in US infrastructure projects.  However, until we know how this turns out, there is cause for unease.

Further, while we have no idea of what firm reforms could come out amending Dodd Frank, the provisions that were targeted in Trump’s comments are ones that may improve the banksters’ profitability, provide less consumer protection and increase the odds of another 2009 too-big-to-fail bailout.  That said, legislative reform seems to have disappeared into the Washington quicksand.

The fiduciary rule rollback (medium and a must read):

Finally, this week Trump addressed at least one of his key campaign pledges: tax cuts.  As I noted above, his comments were woefully short of details; but at least we know that something will be on the table in the next couple of weeks.  To be fair, the link to John Mauldin’s last post suggested that tax reform is definitely in the works and would be all encompassing. 

Providing some details of the plan is Grover Norquist, head of Americans for Tax Reform (must read):

If Grover’s summary as anywhere close to the truth then (1) making the tax code simpler and fairer will be a plus in any time frame and (2) it will also likely provide an initial spur to growth [the good  news] and inflation [the bad news].   However, if that occurs, it the Fed will almost assuredly become more aggressive in raising interests.

In addition, I stand by my earlier comments that ‘the math of huge tax cuts and major infrastructure spending 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.
                        Here is the aforementioned math (medium and an absolute must read):

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.  

Blessed silence.

(4)   geopolitical risks: I continue to worry about Trump’s seeming willingness to throw diplomacy aside and treat the rest of the world like they are the press.  To be clear, I don’t have an issue with most of the principles behind his offensive comments. And I understand that he may just be trying to set up a negotiating position.

The problem, at least as I see it, is that by publicly insulting a country/foreign leader, he puts them in a position of losing face if they knuckle under.  Sure the US is the 900 pound gorilla in the room but why use that power to try to browbeat a country/leader into submission in front of the rest of the world?  It makes the US look like a bully.  More importantly, you never know when are going to need their help on an even more important issue.  Finally, it runs the risk of the other party being willing to accept the pain out of shear stubbornness and then nobody wins.  Life would be so much easier if he simply delivered the message privately, held a meeting/conference and came up with a ‘new’ agreement that both side supported. 

That said, to give credit where it is due, I am sure the Japanese didn’t decide to invest in US infrastructure projects out of the goodness in their hearts.  It is likely the first counter move to assuage Trump in his campaign against the currency devaluations by our trading partners.  Further, he did manage to have a friendly conversation with the Chinese president in which he vowed to honor the ‘one China’ policy.

My principal point here is that, in my opinion, duking it out with foreign leaders in public increases the odds of a misstep that could be costly in far more ways than just economically.

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

[a] December German factory orders were strong but industrial output fell; French economic uncertainty rose; fourth quarter UK industrial output was better than anticipated,

[b] January Chinese services and composite PMI’s, car sales were below estimates and foreign exchange reserves declined substantially; but January imports and exports were stronger than projected, though there was likely some seasonal influence,

[c] January Japanese retail sales were below expectations,

[d] Greece and its creditors remain unable to reach an agreement on the current phase of its bail out.

This week’s data took a decidedly negative turn in the midst of what has been an upbeat trend.  I don’t think this takes the odds of an improved global economy off the table; but it clearly delays a call to that effect.  Hanging in the background are the continuing potential economic/financial problems in Italy, Greece, China, Mexico, Turkey and the UK.

            Bottom line:  the US economic stats were quite upbeat this week---a tiny boost to those hoping that the economy is currently improving.  In addition, the Donald continues his drive for deregulation and that is a decided plus.  Finally, he addressed the tax cut issue, though it was more of a pep talk than a plan; and he certainly didn’t speak to the major problems associated with a big tax cut: the math and congress.  Net, net, at this moment, what has been accomplished to date may only modestly alter long term secular growth rate of the economy.

Foreign economic data the week was disappointing but doesn’t take the possible revision to our ‘muddle through’ scenario off the table.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were up,

(2)                                  consumer: month to date retail chain store sales grew more rapidly than in the prior week; December consumer credit rose less projected; weekly jobless claims fell versus an anticipated increase; February consumer sentiment was well below estimates,

(3)                                  industry: December wholesale inventories were flat, but sales soared,

(4)                                  macroeconomic: the December trade deficit was slightly less than forecast; January import prices were much higher than consensus, while export prices were line.

The Market-Disciplined Investing

The indices (DJIA 20269, S&P 2316) had another good day as investors remain overjoyed by the promise of a coming tax proposal.  Volume declined, but remained at a high level; breadth was strong.   The VIX (10.8) slipped further, finishing below its 100 and 200 day moving averages (now resistance) and in a short term downtrend but is near the lower boundary of its intermediate term trading range (10.3)---leaving complacency at a near record high level.
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 {18742-20784}, [c] in an intermediate term uptrend {11758-24613} 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 {2188-2531}, [d] in an intermediate uptrend {2042-2643} and [e] in a long term uptrend {881-2500}.

The long Treasury declined slightly, continuing to give back much of Wednesday’s gain and hampering its attempt to reestablish the recent two week recovery.  It remained 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 gained, closing within a very short term uptrend and above its 100 day moving average (now support).    It finished below its 200 day moving average (now resistance) and within a short term downtrend. 

The dollar rose, ending above its 100 day moving average (now support), its 200 day moving averages (now support) and in a short term uptrend.  

Bottom line: the S&P remained above the 2300 level.  If it closes above that level on Monday, it will set up a challenge of the upper boundaries of the Averages’ long term uptrends---made easier by the lack of any technical resistance above 20000/2300.  While I remain skeptical that they can be successfully penetrated, it, nonetheless, means another possible 6-8% increase on the upside.
            The dollar and GLD continue to push against resistance levels.  But the sharp setback in TLT raises the question as whether it can keep up.  Certainly, if the Trumpflation trade reasserts itself as a result of the tax cut promise, one would expect higher interest rates, a stronger dollar and possibly higher gold prices---though that is less clear. 

Fundamental-A Dividend Growth Investment Strategy

The DJIA (20269) finished this week about 58.5% above Fair Value (12782) while the S&P (2316) closed 46.5% 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 quite upbeat.  Some may want to read that as the beginning of a growth spurt.  Certainly, 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 pro Market regulatory/fiscal policies from the new administration.  I think more information is needed to draw that conclusion.

Politics continues to dominate the headlines, this week the highlights were on the ongoing battle over the Trump’s travel ban, the consent process on his executive appointees and the promise of a ‘phenomenal’ tax plan. The latter could potentially impact the economy, though the arithmetic points at it being more negative than positive.  But as we know, the Market loves it; and at the moment, that is all that matters.

As you know, I have objected to a number of the Donald’s early moves that do have an impact.  I don’t like his muscling corporations on the thesis that this just another form of regulation.  Nonetheless, to date, companies seem to be going along with his ‘build in America’ push---the latest example being a major project announced by Intel.  However, it remains to be seen if their actions will maximize the economic benefits to the country.  On the other hand, we all can only applaud his efforts to cut government contract costs (see Boeing and United Technologies).

I also have a major problem with Trump’s push towards tariffs and manipulating the dollar lower.  Free trade is and always has been an agent of economic progress and global political stability.  His proposals would inhibit those objectives.  Although I have acknowledged that his moves may be nothing more than initial negotiating positions from which positives can be derived.  Supporting that notion is the recent proposals by the Japanese to invest a substantial amount in US infrastructure projects.  Still the evidence to date keeps this factor as a negative.

Of course, the standout item of the week was the Donald’s promise of a ‘phenomenal’ new tax plan.  While that is all he had to say, there were indications from several good sources that this plan truly is one of import.  One of its goals appears to be making the tax code simpler and fairer.  That is a plus for all of us, period.  The other objective (a large net tax cut) is a bit more dicey.  For one, congressional leaders have raised concerns about increasing the deficit.  And number two is the molasses like pace of the legislative process. He may present the greatest tax reform program ever known to man and it could still take forever to get enacted, and maybe not even then. 

The larger issue in all this is one that I have repeated probably too many times; and that is that the math of a net large tax increase doesn’t work absent a decline in spending---which would be in direct contradiction to Trump’s other main economic goal---increased infrastructure spending.  The US budget deficit and level of government debt are simply too massive to allow tax cuts and infrastructure spending of the magnitude Trump has suggested to have a positive impact on growth---in the absence of the aforementioned offsetting spending reductions. 

Of course, that doesn’t mean that the tax cuts and spending won’t happen anyway.  But (1) studies have shown that when deficits and debt reach a certain level, more debt and deficits inhibit not simulate growth and (2) if the Fed has an ounce of integrity left, it will almost certainly get more aggressive in its rate hikes.  And that (raising the rate at which earnings are discounted) is the most likely trigger for unwinding of asset mispricing and misallocation.  Neither of the above are particularly Market friendly. 

Finally, I don’t believe that the Donald’s unnecessarily hostile rhetoric when addressing foreign leaders is conducive to accomplishing his objectives.  To be clear, I have no disagreement with most of his goals.  In just seems to me that they can be more easily achieved without putting these leaders in a spot from which they either have to lose face by knuckling under to a perceived bully or stand and fight a battle that both they and the US could be losers.  An unstable international environment tends not to be good for stock prices---and that is what we are concerned with here.

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.  Certainly, the construction of the Keystone pipeline, the suspension of agency awarded contracts and reform of the aviation infrastructure will have a positive economic impact---but not on the scale of obstructing free trade and the enactment of a budget busting tax cut and infrastructure spending plan.

This week’s international stats were negative but that doesn’t necessarily mean the end of the trend towards a more upbeat global economy.  On the other hand, it might.  We just need more data.  In the meantime, I am still worried about a number major problems (Brexit, currency problems, free trade issues) looming out there.

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 if that an major increase in deficit spending will likely push the Fed toward higher interest rates and a tighter money supply.  And 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.  In any case, at least according to the math in our Valuation Model, equities are way overpriced.

                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                                               20269            2316

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.

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