Saturday, March 25, 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                                 19148-21431
Intermediate Term Uptrend                     11884-24736
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                                     2234-2568
                                    Intermediate Term Uptrend                         2072-2678
                                    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 is providing an upward bias to equity valuations.   This week’s data was neutral:  above estimates: February new home sales; the Chicago Fed national activity index, fourth quarter current account deficit; below estimates: February existing home sales, weekly mortgage and purchase applications, month to date retail chain store sales, weekly jobless claims and the March Markit flash composite PMI; in line with estimates: February durable goods orders.

 The primary indicators were also neutral: February new home sales (+), February existing home sales (-) and February durable goods orders (0).  Other factors to consider are the anecdotal evidence we are getting from the used car, student loan, oil and retail sales sectors, all of which are doing poorly.  The question is, are these stats false flags or precursors to lousy data in the macro indicators?  Time will tell us.   As you might expect, I am scoring this week as a neutral: in the last 77 weeks, twenty-five were positive, forty-three negative and nine 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, at least, seems to be stabilizing if not 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, especially in light of this week’s anecdotal numbers.

On the political side, it was all about passage of the healthcare bill---which didn’t happen. As you know, Trump issued an ultimatum to either pass the bill on Friday or he was moving on.  Then the GOP pulled the bill.  Probably a good move, though one of the benefits of reforming healthcare was that it would reduce costs that could be used to offset tax cuts.  Given the senate’s strong opposition to increasing the budget deficit, that is going to make any tax reform that is not revenue neutral all the more difficult. 

Not that a revenue neutral tax reform wouldn’t be a plus if it simplified and was more fair.  It just wouldn’t have the supposed stimulative effect that a cut is thought to have.  That last sentence was obviously a hedged one because as I have repeatedly opined, an increase in the budget deficit from current levels has been shown to be a negative to economic growth.  So a revenue neutral tax reform is likely the good news scenario; though I suspect that dreamweavers will be disappointed.

In addition, the State Department approved the Keystone pipeline.   This adds emphasis to the point I made last week that Trump’s effort downsizing and rationalization of the bureaucracy will likely have a bigger impact on the economy than I originally forecast.   Indeed, I am adding 25 to 50 basis points to our long term economic secular growth rate assumption.  That, of course, sounds a good deal more precise than I want to be; but you have to start somewhere.  So just be aware that this number could easily go higher or lower.

Oil prices continued their decline this week.  As you know, I am not surprised by this given my skepticism about OPEC’s ability to follow through with proposed production cuts.  Of course, it is doing all it can to salvage the production cut agreement.  In fact, it is meeting this weekend to ‘assess the effectiveness of the production cuts’.  I could save them the time and expense by pointing to the obvious.  Nonetheless, I would expect another bulls**t statement from this group aimed at papering over its lack of success.  My point in including this discussion is that the last round of oil price declines was not good for the economy.  I don’t expect this time will be any different.

While trade policy has played second fiddle to the healthcare bill of late, it is still an ‘….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 almost nonexistent; but what we got was positive.  That leaves our ‘muddle through’ scenario in place but also leaves open the possibility that our forecast could be upgraded.  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 neutral, neither helping or hindering 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, based on the likely positive impact of Trump’s deregulation efforts, I am upgrading our long term secular growth rate by 25 to 50 basis points.   

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. 

Holding center stage this week was the healthcare drama---which in the end played out as a tragedy.  From the standpoint of the healthcare plan itself, I am not sure it is all the bad because [a] given the opposition in the senate, it wasn’t clear at all that it would ultimately pass anyway and [b] as I understand the issues that were preventing agreement among the GOP, the plan as presented had enough liabilities that it could very well have ended up ultimately as a negative.  So I am not that upset that a bad bill wasn’t replaced by a somewhat less bad bill.  Further, from a political point of view, Obamacare is still owned by the dems. 

To be sure, a lack of reform of Obamacare is a negative.  The fact that the republicans couldn’t manage the repeal and replace process hurts (1) the Market’s image of Trump the dealmaker, (2) lays bare the popular assumption that healthcare and tax reform along with increased infrastructure spending were somehow a slam dunk---the everything is awesome scenario.  But I never believed that line anyway and (3) it impacts tax reform because the large tax savings from Obamacare was planned to be used for tax cuts.

As I noted above the Keystone pipeline received State Department approval this week.  This is another positive in the Donald’s deregulation effort which I believe will have a positive impact on the US economy; so much so, that as I also noted above, I am raising our assumption on the long term secular growth rate of the economy.  It is not going to put back in the historical range; but it is a move in the right direction.

The bottom line here is that (1) deregulation is lifting our economy’s long term growth prospects, (2) the Trump/GOP election victory was not the magic elixir that many seemed to believe, (3) however, I believe that they will still achieve some form of tax reform and infrastructure spending legislation which will also prove beneficial to the economy’s long term growth but (4) the restraint on accomplishing aggressive tax and spending programs is not GOP harmony but math.  In my opinion, they simply won’t get done and if they do, it will be more harmful than beneficial.

As a final note, some of the above is political speculation on my part---something that is above my pay grade.  So take it for what it is worth; which is very little.

(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.  

Not much to discuss this week.  The news on monetary policy came from overseas as [a] the Bank of Japan said that there was little reason to tighten and [b] the ECB’s latest round of bond purchases was more aggressive than had been expected.  So it looks like these guys are at odds with Yellen & Co---they having raised rates last week. 

But I don’t think the spread is that great.  As I opined last week, I believe the only reason the Fed raised rates was because the bond market forced it.  I think that the Fed would be perfectly happy to not hike rates again; and given that the bond market continued its turnaround [rally] this week, I think that takes the pressure off the Fed for further rate hikes.  As you know my thesis has always been 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.  So any excuse to delay lifting rates is a God send. 

Of course, the other part of my thesis is that I believe that the Fed is way behind schedule in raising rates.  But 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. 

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.

(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.

(1)   economic difficulties in Europe and around the globe.  Another slow week for the release of global economic numbers: February UK inflation was higher than expected; and the March EU flash composite PMI rose, hitting a six year high.

In other news, the UK triggered the Brexit process; Greece said it would likely fail to achieve results necessary to receive the next round of bailout money; and most concerning the G20 failed to renew a pledge to resist all forms of protectionism.

In sum, this week’s data was parse but what there was, was upbeat.  Still not enough to add to or detract from any judgement about the trend.  So there is little incentive to alter our ‘muddle through’ forecast.

            Bottom line:  the US economic stats appear to be stabilizing.  More importantly, the Donald’s drive for deregulation and improved bureaucratic efficiency is a decided plus.  On the other hand, the turmoil over the healthcare bill is a good illustration that the Donald’s fiscal program has a rocky road ahead of it however great it may sound on paper.  I continue to believe that something positive will come from changes in fiscal policy; and they will likely be enough to alter our long term secular economic growth rate assumption in our Models.  However, I also believe that they will take longer and have less impact than seems to be Street consensus at this time.

This week’s data:

(1)                                  housing: February existing home sales were disappointing while new home sales were off the charts; weekly mortgage and purchase applications were down,

(2)                                  consumer: month to date retail chain store sales growth slowed from the prior week; weekly jobless claims rose considerably more than estimates,

(3)                                  industry: February durable goods orders were above forecast but ex transportation they were below; the February Chicago Fed national activity index was much better than consensus; the Kansas City Fed manufacturing index was above projections; the March Markit flash composite PMI was below expectations,

(4)                                  macroeconomic: the fourth quarter current account deficit was less than anticipated.

The Market-Disciplined Investing

The indices (DJIA 20596, S&P 2343) ended slightly lower following the pulling of house Trumpcare bill.  Volume rose; breadth was weak.   The VIX (13.1) was up, ending above the lower boundary of its very short term uptrend, above its 100 day moving average for the third day (it now reverts to support), below its 200 day moving average (now resistance) and in a short term downtrend.  It appears that the thesis that the period of complacency could be ending remains in place.
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 {19148-21431}, [c] in an intermediate term uptrend {11884-24736} 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 {2236-2570}, [d] in an intermediate uptrend {2072-2676} and [e] in a long term uptrend {881-2561}.

The long Treasury was up fractionally, but remained above its 100 day moving average for the third day (it now reverts to support), below its 200 day moving average (now resistance) and in a very short term downtrend.
GLD rose slightly, but finished above its 100 day moving average (now support), below its 200 day moving average (now resistance) and within a short term downtrend. 

The dollar inched higher, but ended below its 100 day moving average (now resistance), above its 200 day moving averages (now support) and in a short term uptrend.

Bottom line: all of our indices have broken short term support/resistance levels.  Whether that is just noise, reflects consolidation or the start of a directional change, I don’t know.  But we need to be alert in case it is the latter.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (20596) finished this week about 60.6% above Fair Value (12823) while the S&P (2343) closed 47.7% 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 mixed though the anecdotal reports were something a good deal less.  Still the recent trend in the numbers suggest that the economy has less downside than I had feared, though I am not sure of the magnitude of any upside.  Yes, I am raising the long term secular economic growth rate in our Models based on Trump’s good work at deregulation.  And yes, I will likely raise it even more once we know the magnitude and timing of any new fiscal policies.  But (1) increasing the secular long term growth rate potential of the economy does nothing for the forecast for the next 12 months and (2) as I have continually pointed out, the math of substantial tax cuts and/or major infrastructure spending just doesn’t work.  As a result, I think that if our improved short term and long term growth assumptions for the economy are anywhere near correct, they will likely still be a disappointment to many on the Street.

Further, 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.    However, the initial responses to his efforts by both Mexico and the G20 belie that notion, leaving me concerned that this factor could prove to be 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 changes already made in regulatory policy and the potential improvements coming in fiscal policy, I caution investors not to get too jiggy about the rate of any accompanying acceleration in economic growth and corporate profitability.  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 are beginning to improve as we learn about the new fiscal/regulatory policies and their magnitude.  However, I think the timing and magnitude of the end results will less than the current Street narrative suggests---which means Street models will ultimately will have to lower their consensus of the Fair Value for equities. 

Our Valuation Model are also changing as I raise our long term secular growth rate assumption.  This will, in turn, lift the ‘E’ component of Valuations; but there is a decent 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, even with the improvement in our growth assumption the math in our Valuation Model still shows that 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                                               20596            2343

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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