Saturday, March 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                                 18881-21182
Intermediate Term Uptrend                     11815-24667
Long Term Uptrend                                  5751-23298
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2211-2545
                                    Intermediate Term Uptrend                         2057-2661
                                    Long Term Uptrend                                     881-2561
                        2016   Year End Fair Value                                      1560-1580
2017 Year End Fair Value                                       1620-1640         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          57%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        55%

The Trump economy will likely provide an upward bias to equity valuations.   This week’s data was weighed to the plus side:  above estimates: weekly mortgage and purchase applications, the December Case Shiller home price index, month to date retail chain store sales, February consumer confidence, weekly jobless claims, January personal income, the Dallas and Richmond Fed manufacturing indices and the February ISM manufacturing and nonmanufacturing indices; below estimates: January personal spending, February retail chain store sales, the February Markit manufacturing and services PMI’s, January durable goods orders, January construction spending, revised fourth quarter GDP and the January trade deficit; in line with estimates: none.

 On the other hand, the primary indicators were almost all negative: January personal income (+), January personal spending (-), January durable goods orders (-) January construction spending (-) and revised fourth quarter GDP (-). 

Adding a little flavor to our weekly assessment was (1) the Fed released its latest Beige Book which read pretty much as expected---the economy modestly improving, (2) the Atlanta Fed lowered their first quarter GDP growth estimate to 1.9% and (3) the latest update to the big four economic indicators which for the first time in over a year were negative.

I am going to score this as a neutral; though I am bending over backwards for the optimists: in the last 74 weeks, twenty-four were positive, forty-two negative and eight neutral.

Speaking of optimists, they have to be very uneasy trying to sell this week’s stats as a weak continuation of the prior two weeks’ upbeat dataflow which in turn is supposed to be an indication of a pickup in the numbers due to the improved post-election Market sentiment being translated into a more rapidly growing economy.  While I have put myself in that camp, I recognize the fragility of that case.

On the political side, Trump delivered his state of the union address.  While it generated much enthusiasm (as an aside, I thought the absence of vindictiveness and self-aggrandizement was the most important takeaway), few details on repealing and replacing Obamacare, tax reform and infrastructure spending were forthcoming.  He did announce an increase in defense spending to be offset by cuts in other government agencies but the order of magnitude of these measures was more symbolic than economically significant. 

In short, all we have on the issues of taxes and spending is rhetoric and included in that rhetoric is nothing about the current budget deficit or the level of federal debt.  And we know that because of this absence, there is dissention in the GOP ranks on all these issues---meaning it will likely be a tough slough getting from rhetoric to enactmentf that case
inting at an improving economy and a tightening Fed.moving average, keeping alive the hope .  Finally, if the studies of Reinhart and Rogoff are to be believed, tax cuts and infrastructure spending unaccompanied by offsets will be counterproductive in stimulating economic growth.  The point here is that the magnitude and timing of fiscal change may be less than many hope for.  I, for one, am not altering our longer term secular forecast until we see the whites of their eyes.

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 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.

Overseas, the data this week was again very upbeat, supporting the notion that there is a decent probability that the ‘muddle through’ scenario gets replaced by an improving economy.  While it still a bit too soon to make that call, another couple of weeks of solid positive stats would likely push me to do so.  That said, there are still problems out there that could stop a recovery in its tracks: 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. 

Bottom line: this week’s US economic stats were neutral, neither helping nor damaging the notions that either the economy is improving or is about to improve based on increasing investor sentiment.  More is needed before I will feel confident with my revised tentative short term forecast.  But I 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.   

In the meantime, my take is that we are in an economy (1) that is making only sluggish headway, (2) in which the known Trump economic policy changes are not that encouraging [‘border’ tax; currency valuation] and (3) the unknown [Obamacare reform and infrastructure spending] policies have yet to be addressed in any meaningful way, but which may be about to change. 

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.’
       The negatives:

(1)   a vulnerable global banking system. The Greek bail out, or lack thereof, continues to hang around like a bad case of herpes.  The euros seem unable to resolve this problem; and while the fallout from a Grexit and redenomination of Greek government debt may by itself have only a marginal impact, the Markets now starting to get squirrelly about Spanish, Italian and French debt, meaning such an occurrence could have a domino effect. 

However, as I have said before, the EU ruling class has always been masterful in pulling a rabbit out of the hat at the eleventh hour that allowed all to muddle through---and, indeed, that has been our forecast for years.  Still there is a risk in assuming they will do it one more time.

(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, his efforts at deregulation are a positive.

However, to date we have almost no parameters for healthcare reform or infrastructure spending, other than broad promises.  The details on tax reform are more well developed; though there appears to be opposition on the border tax element of this legislation as well as its potential impact on the budget deficit. 

Please understand, I don’t think Trump is blowing smoke up our skirt about his intentions to follow through with all of the above.  But the key to getting any of these measures enacted is, as it always has been, to achieve compromise.  And compromise means getting less than you hoped for. 

In addition, there is still almost no discussion about the debt ceiling freeze coming on March 15th.  And the point here is that not only does Trump/GOP need to pass all the aforementioned legislation, compromised or not, but also if any of it will lead to a violation of the debt ceiling, then additional legislation will be need to raise that limit.  In essence, the bills will have to be passed twice.  So while I believe that some action on Obamacare, taxes and spending will occur, trying to create an economic forecast based on the as yet unknown particulars is probably an exercise in futility.  

Finally, Trump’s comments on trade demonstrate the seeming lack of understanding of what free trade has meant to global prosperity and peace.  Plus trying to talk down the dollar only generates similar responses from our trading partners, which in the end accomplishes nothing expect fostering ill will. 

That said, 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.  Certainly, Friday’s comments from Wilbur Ross provides some hope of that.  However, until we know how this turns out, there is cause for unease.

This is a great discussion on possible changes in NAFTA, the implications of the border tax and how this would all play in the global trade arena.  It is a bit long but worth the time.

(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.  

Update on auto loans (short):

This week Fed members were out in force, trumpeting the case that an improved economy calls for higher rates---quite a change from the Casper Milquetoast tone of last week’s FOMC minutes.  Yellen added her two cents worth on Friday, saying that a March rate hike would be appropriate [on the one hand] assuming [on the other hand] next week’s nonfarm payroll number is a positive. 

Of course, what the Fed says and what it does have very seldom been correlated. And while I have embraced the notion of a modestly improving economy driven by better sentiment, the numbers still aren’t that great---witness this week’s primary economic indicators and the downward revision of first quarter GDP by the Atlanta Fed.  Meaning one wonders what is driving the Fed’s enthusiasm for a rate hike.  (hint: Dow 21000)

So all other things being equal, I could easily see the Fed chickening out at the eleventh hour.  But all things are never equal; this time it is the pin action in the bond pits which has driven the odds of a March rate hike to over 70%.  While I take Fed rhetoric with a grain of salt, when the bond markets speaks, I listen.  So I think it a reasonable probability that a second Fed funds rate hike is on the way, soon. 

In addition to the Fed, the ECB also meets next week.  As I have been chronicling, the EU economy has been making a major turnaround over the past couple of months.  So the pressure is also increasing on Draghi to begin normalizing EU monetary policy.

Clearly, that moves forward my scenario that a tightening Fed will do little to impact the economy but will have a significant effect on asset pricing and allocation.

(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.

My 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, the global economic numbers continued the recent trend towards improvement:

[a] the February EU Markit composite, manufacturing and services PMI’s were above projections as was economic sentiment, while the UK manufacturing and services PMI were below; February EU CPI was over 2% {ECB’s goal} while PPI came in at 3.5%; fourth quarter UK GDP growth was revised higher; February German business was better than expected; the French fourth quarter GDP was up more than anticipated,

[b] the February Chinese manufacturing PMI rose from the prior month while the services PMI declined

                  [c] January Japanese CPI rose for the first time in over a year.

On the other hand, news reports indicated that the bankruptcy problems at Italy’s Monti Paschi and the Greek bailout have not been resolved  If history repeats itself the EU ruling class will come up with a band aid that will buy more time; but that won’t solve the problems.  Ultimately somebody has to swallow some bitter medicine.

In sum, this week’s data keeps the global economy on its winning track, leaving a change in our forecast on the table.  We are just not quite there yet.  Part of my hesitation is because of the continuing potential economic/financial problems in Italy, Greece, China, Mexico, Turkey and the UK.

            Bottom line:  the US economic stats were neutral---little help to those hoping that the economy is currently improving.  On the other hand, the Donald continues his drive for deregulation and that is a decided plus.  Finally, while there has been a lot of dialogue about taxes, spending, Obamacare, trade, nothing is even in writing much less close to enactment.  In other words, while I am hopeful that Trump will be able to deliver on his promises, it is too soon to be building economic models assuming some specific outcomes.  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 this week improved, leaving open the possible revision to our ‘muddle through’ scenario.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were up; January pending home sales were worse than forecast; the December Case Shiller home price index rose more than anticipated,

(2)                                  consumer: January personal income was above projections but personal spending was below; month to date retail chain store sales growth improved from the prior week while February sales were weaker than in January; February consumer confidence smoked consensus; weekly jobless claims were quite positive,

(3)                                  industry: January durable goods orders were in line, but the December reading was marked down big and the ex transportation number was lousy; January construction spending was really bad; the February Dallas and Richmond Fed manufacturing indices were much better than expected; the February Chicago PMI was above estimates; somewhat confusingly the February ISM manufacturing and nonmanufacturing indices came above projections while both the February Markit manufacturing and services PMI’s were below,

(4)                                  macroeconomic: fourth quarter GDP fell short of forecasts; the January US trade deficit was greater than anticipated.

The Market-Disciplined Investing

The indices (DJIA 21182, S&P 2383) continued to consolidate after Wednesday’s strong performance.  Volume fell, but remained at a high level; breadth was mixed.   The VIX (10.9) was down 7 ¼%, ending 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)---leaving complacency at a near record high level.
The Dow closed [a] above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] in a short term uptrend {18881-21182}, [c] in an intermediate term uptrend {11815-24667} and [d] in a long term uptrend {5751-23298}.

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 {2211-2545}, [d] in an intermediate uptrend {2057-2661} and [e] in a long term uptrend {881-2561}.

The long Treasury was up, ending right on the lower boundary of that developing pennant---which it had violated on Thursday.  It remains below its 100 and 200 day moving averages and in a very short term downtrend.

GLD voided its very short term uptrend but still closed above its 100 day moving average (now support).  Nevertheless, it ended below its 200 day moving average (now resistance) and within a short term downtrend. 

The dollar was up, ending above its 100 day moving average (now support), its 200 day moving averages (now support), in a short term uptrend and seems to have set a new very short term uptrend.  

Bottom line: the Averages continued their relentless move to the upside.  The assumption has to be that they are headed for the upper boundaries of their long term uptrends.  Bonds, the dollar and gold are all pointing at an improving economy and a tightening Fed.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (21182) finished this week about 65.2% above Fair Value (12823) while the S&P (2383) closed 50.3% overvalued (1585).  ‘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 were a draw.  Some may want to read that as more evidence that a growth spurt is in the making; but the primary indicators, the Atlanta Fed’s revisions in its first quarter GDP forecast and the latest update on the big four economic indicators suggest otherwise.  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 highlight was Trump’s state of the union which sounded great but was woefully short of specifics.  Last week, I opined that ‘the reality of the legislative process and math seem to be working their way into the discussions on tax cuts and infrastructure spending’.    But the Market seems to have not grasped that same reality quite yet; at least judging by its response to the Donald’s speech which was about all things but math. 

Not that tax reforms and infrastructure spending won’t happen.  Indeed, I may very well make upward revisions in our forecast for GDP and corporate profit secular growth and that could in turn positively impact stock valuations in our Model.  But ‘may’ is the operative word because, at this moment, we are woefully short of details.  On the other hand, many on the Street have already made huge changes in their forecast based on, what I believe, are extraordinary leaps of faith on what will be enacted. As long as this remains their perspective, the gap between reality and the numbers in their models will persist.  And the risk is that those forecasts won’t materialize.  That said, at the moment, hope is all that matters to the Market; but if I am correct, then ultimately those models will change for the worse.

While talk of trade and currency has been out of the headlines of late, I remain concerned about 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.    Still the evidence to date keeps this factor as a negative.

This week’s international stats were positive, increasing the likelihood of a change in international segment of our economic forecast.  I still need more data.  In the meantime, I am worried about a number of major problems (Brexit, currency problems, free trade issues) looming out there.

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. 

As you know, 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.  If the bond Markets are correct in their assessments that the Fed is about to get more aggressive in monetary tightening, that could start the process.  In addition, while I am encouraged about the potential changes coming in fiscal/regulatory policy, I caution investors not to get too jiggy about the rate of 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 3/31/17                                  12823            1585
Close this week                                               21182            2383

Over Valuation vs. 3/31 Close
              5% overvalued                                13464                1664
            10% overvalued                                14105               1743 
            15% overvalued                                14746               1822
            20% overvalued                                15387                1902   
            25% overvalued                                  16028              1981
            30% overvalued                                  16669              2060
            35% overvalued                                  17311              2139
            40% overvalued                                  17952              2219
            45% overvalued                                  18593              2298
            50% overvalued                                  19234              2377
            55%overvalued                                   19875              2456
            60%overvalued                                   20516              2536
            65%overvalued                                   21157              2615
            70%overvalued                                   21799              2694

Under Valuation vs. 3/31 Close
            5% undervalued                             12181                    1505
10%undervalued                            11540                   1426   
15%undervalued                            10899                   1347

* 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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