Saturday, March 18, 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                                 19082-21321
Intermediate Term Uptrend                     11839-246697
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                                     2231-2565
                                    Intermediate Term Uptrend                         2069-2673
                                    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 heavily weighed to the plus side:  above estimates: weekly mortgage and purchase applications, February housing starts, the March housing market index, month to date retail chain store sales, weekly jobless claims, March consumer sentiment, the March NY and Philadelphia Feds’ manufacturing indices, the February small business optimism index and the February leading economic indicators; below estimates: February retail sales, February industrial production, January business inventories/sales and February PPI; in line with estimates: February CPI.

 However, the primary indicators were neutral: February housing starts (+), the February leading economic indicators (+), February retail sales (-) and February industrial production (-).  Other factors to consider were (1) the FOMC meeting which raised the Fed Funds rate 25 basis points but delivered a Goldilocks narrative [the economy is improving enough not to be hampered by any rate increases] and (2) on the same day, the Atlanta Fed lowered their first quarter GDP growth estimate to 0.9%.  Anyone but me see the irony here?

Given the magnitude of the positive indicators, I am scoring this week as a plus: in the last 76 weeks, twenty-five were positive, forty-three negative and eight neutral.

Net, net, the recent trend in the data has been mildly upbeat. It is not as good as much of the narrative on Street would have you believe; but it does seem to be improving.  So perhaps the thesis that economic growth would start to mend post-election due to a pickup in sentiment is being played out.  While I have bought into that notion, I still feel a bit uncomfortable with it.

On the political side, Trump delivered his first budget to congress; and it contained some major spending shifts (more defense spending, less domestic discretion spending, mostly in the form of cuts in government agencies budget).  Everyone opined that it was DOA; but that is just politics.  Certainly there will be compromise.  But if the final product starts a transition away from funding the US bloated bureaucracy, that will be a major accomplishment.  Along those lines, he also issued an executive order authorizing a review of all government departments with the aim of making them more efficient. 

I have to tell you that I am pleasingly surprised at the extent to which Trump is pushing downsizing and rationalization of the bureaucracy.  So much so that I think that it will have a bigger impact on the economy than I originally forecast. On the other hand, I continue to question the magnitude and timing of fiscal reforms---the potential benefits of which I believe have been way over estimated by investors.  But the net of both of these factors is a larger positive than I have been assuming.  Indeed, if the only thing the Donald achieves is a more efficient, less costly federal government bureaucracy that alone will raise the long term secular growth rate of the economy.  I haven’t put a number on it yet; but I soon will.

In another development in the political sphere, the CBO issued its scoring of the new GOP version of healthcare---and it was not a favorable one for the forces of change.  Still, if it can lead to revisions to the plan then it will have done all a service.  The point here is that the fiscal side of Trump’s agenda, in my opinion, is going to be (1) a long drawn out affair and (2) will likely fall considerably short of current expectations.  Of course, I am of the opinion that tax cuts and infrastructure spending unaccompanied by offsets will be counterproductive in stimulating economic growth anyway. 

That said, Friday afternoon, it looks like Trump/Ryan are moving towards a consensus within the GOP house on healthcare.  There is still a ways to go; and that doesn’t account for opposition among senate republicans.  Still credit where credit is due.

Finally, oil prices took it in the snoot this week.  Whether this continues is a matter of debate.  As you know, I have been a skeptic about OPEC’s ability to follow through with proposed production cuts.  So from my perspective, there are better than even odds that further price declines are in the cards.  As always there are two views of the economic impact of weaker oil prices: (1) the unmitigated positive crowd and (2) those who look at the facts.  And the facts are that the last time this happened, the economy slowed.  The downdraft in prices to date probably isn’t enough to influence the direction of the economy; but if this trend continues, I believe that growth forecasts will start coming down.

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 almost nonexistent; so the notion that there is a decent probability that the ‘muddle through’ scenario gets replaced by an improving economy is still operative.  While it may be 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 was positive, helping the thesis 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.  On the other hand, I have no intention of altering our long term secular growth rate outlook until I see concrete results of the Trump/GOP fiscal agenda.   

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 spending 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. Nothing new this week.

(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.  The latest example is an executive order signed this week that called for the comprehensive reorganization of the executive branch.  This could potentially have far reaching consequences in terms of streamlining the government and reducing operating costs.  That said, expect a massive pushback from the entrenched bureaucracy; so it will be a lot easier said than done.  Nonetheless, it is a big boost for the ‘deregulation’ element of Trump’s policies; and as I noted above, it is likely meaningful enough to warrant some increase in our long secular growth forecast.

On the other hand, it is becoming obvious that fiscal policy changes are going to be very difficult.  The Donald has pissed off the dems so much that I don’t think that they would vote a recommended pay raise for themselves.  That means that virtually all the heavy lifting has to be done by the GOP led congress which, at the moment, appears very disjointed with respect to their own set of priorities. 

Topping the list is the repeal and replacing of Obamacare. Given the diversity of opinions among the republicans, the timeframe for likely passage keeps getting moved out, suggesting that nothing will be enacted until the fall, if then.  Unfortunately, tax reform can’t be done until the tax consequences of healthcare reform are known.  So we will be lucky to get legislation on that score this year; and if that doesn’t occur, then 2018 be even harder since the house will again be running for reelection.

Infrastructure spending comes after that because healthcare and tax reform will have to be scored for changes in revenues/costs before anyone knows how much budget flexibility will exist for extra spending.  Unfortunately, spending faces another hurdle, which is the federal debt cap.  Since the current debt is virtually at that limit, a new cap will need to be enacted before any additional spending can take place [other than any savings that might come from deregulation/reorganization and healthcare reform and/or net new revenues from tax reform]. 

And this sobering piece from David Stockman (medium and today’s must read):

In short, there is a lot of work to do to accomplish any of the Donald’s fiscal pledges.  Even assuming all this gets done, there will of necessity likely be lots of compromises.  So all we have now are the promises of change, the hope that Trump can corral/browbeat the GOP congress into enacting legislation that reasonably reflects those promises and then passing enabling legislation that will pay for it all. 

‘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.’ 

The point here is not to piss and moan about the legislative process.  It is simply to say that we have no earthly idea how the process is going to play out; hence, 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.  

(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 I noted above, the lead headline this week was the FOMC meeting.  The Fed Funds rate was increased an expected 25 basis point; and while the narrative included the forecast for multiple rate hikes this year and next, it was sugar coated---the economy is strong enough to handle the rate increases. 

But to be clear, I don’t believe that it raised rates Wednesday because of the collective, infinite wisdom of a bunch blue sky academics thought that it was time.  Rather, I believe that if the bond market hadn’t pushed rates up, the Fed would have done nothing, despite its upbeat economic outlook. 

That said, I believe that the Fed should be raising rates.  Indeed, you know that I have oft times noted that I believe that the Fed is way behind schedule in raising rates.  And at the risk of being repetitious, I don’t believe that a tightening Fed will side track the economy because its easy money policy [except QE1] did little to help it. 

On the other hand, I also believe that what the Fed really fears is that rising rates will derail the Markets because its QE/ZIRP policies were one of the main drivers of this grossly overvalued Market.  Further, however much the Fed may believe that it can finesse a tightening in monetary policy without disrupting the securities markets, I think that they are smoking dope. 

My bottom line remains that when the unwinding of the global QE/ZIRP/NIRP begins in earnest, I believe that it will have only a modest effect on the economy but a noticeable one on the Markets.

Another stem winder from Jeffery Snider (medium and a must read):

In addition to the Fed, [a] the Bank of Japan met this week and left rates unchanged [b] while the Bank of China raised key benchmark rates for the third month in a row.   My point in bringing this up is that when the major central banks’ monetary policies are at odds, it tends to raise the volatility in the fixed income and currency markets; and depending on just how at odds they are, it can impact trade.

(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.

Saber rattling against North Korea (medium):

(5)   Economic difficulties in Europe and around the globe.  This week, the global economic numbers were very few:

[A] February Chinese retail sales were less than anticipated while industrial output was greater

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

The other news was that the UK parliament voted to begin Brexit talks; but the Dutch left the anti-EU party in the minority.  Notably absent was any update of the bankruptcy problems at Italy’s Monti Paschi and the Greek bailout.

In sum, this week’s data was too sparse as to add to or detract from any judgement about the trend.  That said, since the trend has been towards improvement, I have to leave it intact.  However, it is scarcely a reason to alter our ‘muddle through’ forecast.

            Bottom line:  the US economic stats were positive.  More importantly, the Donald’s drive for deregulation and improved bureaucratic efficiency is a decided plus.  On the other hand, while the dialogue on taxes, spending and Obamacare has picked up as a result of the introduction of the GOP’s new healthcare bill as well as Trump’s first budget, all we are hearing are the reasons neither will be passed.  I don’t buy that; something will be enacted.  I just don’t believe that it will be nearly as significant as many do.  Net, net, at this moment, what has been accomplished to date may only modestly alter long term secular growth rate of the economy.

This week’s data:

(1)                                  housing: February housing starts were ahead of forecasts; the March housing market index was better than anticipated; weekly mortgage and purchase applications were up,

(2)                                  consumer: February retail sales were a bit disappointing; month to date retail chain store sales growth improved from the prior week; weekly jobless claims fell more than estimated; the preliminary March consumer sentiment was better than forecast,

(3)                                  industry: February industrial production was below consensus; the March NY and Philadelphia Feds’ manufacturing indices were better than projected; January business inventories rose but sales grew less; the February small business optimism index was slightly ahead of expectations,

(4)                                  Macroeconomic: February PPI was up more than anticipated; while CPI was in line; the February leading economic indicators were ahead of estimates.

The Market-Disciplined Investing

The indices (DJIA 20914, S&P 2378) continued to consolidate.  Volume jumped dramatically but that was largely a function of quad witching; breadth was weaker.   The VIX (11.3) was unchanged, ending below its 100 and 200 day moving averages (now resistance) and in a short term downtrend.  It closed right on the lower boundary of a very short term uptrend for the second day---having challenged it unsuccessfully intraday on both days.  If it holds above that boundary, then I have to take the thesis that the period of complacency could be ending more seriously.
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 {19082-21321}, [c] in an intermediate term uptrend {11839-24691} 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 {2231-2565}, [d] in an intermediate uptrend {2069-2673} and [e] in a long term uptrend {881-2561}.

The long Treasury was up, but ended below its 100 and 200 day moving averages, in a very short term downtrend and near the lower boundary of its short term trading range.

GLD rose, closing 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 unchanged, ending below its 100 day moving average (now resistance), above its 200 day moving averages (now support) and in a 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. 

Fundamental-A Dividend Growth Investment Strategy

The DJIA (20914) finished this week about 63.0% above Fair Value (12823) while the S&P (2378) closed 50.0% 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 was upbeat but that positive was tempered by mixed primary indicators and a second downward revision in first quarter GDP growth estimate by the Atlanta Fed.  So while the risk of recession may be going down, there is not a lot in the numbers to suggest a major growth spurt.  That said, 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. And here is where, in my opinion, we find the most upbeat news.  Trump continues his effort to reduce regulation as well as the size of the bureaucracy---this week issuing an executive order for a major review of all government agencies with the purpose reducing their power over the economy as well as saving money.  This objective was obvious in his first budget in which there were major cuts in government agency spending. 

On the other hand, given the reception of the new GOP healthcare plan and the aforementioned budget proposal, it seems likely that any changes in Trump’s fiscal plan will be very hard fought, longer in coming and not nearly as impactful as many believe.  Not that something positive won’t come out of these negotiations.  But is simple too soon to be altering forecasts on the probable outcome.  And the rub Market wise is that many investors seem not to have grasped the political and mathematical reality that big tax cuts and major infrastructure spending are not likely to occur.   On the other hand, many on the Street have already made huge changes in their forecast based this misperception; and the risk to the Market 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.

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. 

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.   In addition, while I am encouraged about the potential changes coming in regulatory policy, I caution investors not to get too jiggy about the rate of any accompanying acceleration in economic growth and corporate profitability flowing from any transformation in fiscal policy 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.
                If only I knew when (medium):

DJIA             S&P

Current 2017 Year End Fair Value*              13200             1630
Fair Value as of 3/31/17                                  12823            1585
Close this week                                               20914            2378

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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