Saturday, April 15, 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                                 19305-21635
Intermediate Term Uptrend                     11936-24785
Long Term Uptrend                                  5751-23390
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2261-2594
                                    Intermediate Term Uptrend                         2087-2691
                                    Long Term Uptrend                                     905-2591
                        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, what there was of it, was positive in aggregate: above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, weekly jobless claims, revised March consumer sentiment, March export prices, March PPI and CPI; below estimates: March retail sales, the March small business optimism index; in line with estimates: March import prices.

 However, the one primary indicator was negative: March retail sales (-).   I also want to note that I categorized the weak PPI and CPI numbers as a positive because, in general, falling PPI/CPI is good news on the inflation front.  However, into today’s environment in which (1) the Market consensus has congealed around the Trumpflation trade and (2) the Fed is talking up rate hikes and balance sheet shrinkage, these stats could be read as deflationary, creating cognitive dissonance at the least. 

All that being said, I am going to score this week as a neutral with an asterisk denoting it could have just as easily been scored as a negative: in the last 80 weeks, twenty-five were positive, forty-four negative and eleven neutral.

  As you know, I have been much less impressed with the supposed strength in the economy than many others---even though I bought into the post-election-euphoria-stimulated-economy thesis.  And this week’s numbers don’t really help that conviction.  Indeed, this makes the fourth week in a row of flattish to negative numbers; and that may be suggesting that the economy may be reverting back toward our prior recession/stagnation scenario---which would in turn make those aforementioned inflation numbers bad news.  I am not making that call yet; but it is under serious consideration.

One final point: the April 28th vote to fund government operations or risk a shutdown is not getting near enough attention.  I am not suggesting the latter; but if history is any guide there will at least be a lot of wrangling before the vote that could cause some heartburn.

On the political side, congress was on vacation and the Donald spent most of his time on international affairs this week but did manage to keep the media’s hair on fire with major policy reversals: (1) he now likes a weak dollar, (2) he likes the Import/Export Bank, (3) China is no longer a currency manipulator, (4) he hasn’t decided what to do with Yellen, and (5) NATO is not obsolete.

I applaud Trump’s backing down on Chinese currency manipulation.  That whole thesis was a straw man anyway; and it is another plus for free trade.  Ditto, backing off on beating up NATO.  However, I believe that he is wrong on the dollar (all he has to do is look at the historical relationship of the value of the dollar and the rate of economic growth); and I could care less about Yellen. 

The troubles with Syria and North Korea got a lot of attention this week.  I expand on this below.  But my conclusion is that I can’t imagine either situation leading to anything more serious than threatening headlines.  Still, we have to be open to the chance of either or both of these situations going beyond a war of words. 

Overseas, the data this week was much better than the prior week.  That resumes the somewhat erratic improvement in the global economy and leaves open the possibility of an upgrading of our ‘muddle through’ scenario.  Nevertheless, I remain concerned about the Greek bailout, the worsening liquidity in Italian banking system and the growing odds of an anti-EU president being elected in France.

Bottom line: this week’s US economic stats were mixed.  Whether this is a continuation of a temporary loss of momentum from the Trump bliss or another sign of the end of it, we will just have to await further evidence.  If it is the latter, then short term that could mean that I have to reverse the recent slight increase in our 2017 economic growth forecast.  As I noted above, more is needed to make that call.

On the other hand, based on Trump’s deregulation efforts and his more reasoned approach to trade, I remain confident in my recent upgrading our long term secular growth rate by 25 to 50 basis points.   

Our (new and improved) forecast:

An undetermined but positive pick up in the long term secular economic growth rate based on less government regulation.  This increase in growth could be further augmented by pro-growth fiscal policies including repeal of Obamacare, tax reform and infrastructure spending.  On the other hand, it could prove detrimental if the result is a dramatic increase in the federal budget deficit.  However, it is far too soon to speculate on any outcome.

 Short term, the economy may be losing momentum as the post-election Trump buzz wears off.  If that is the case, then our former recession/stagnation forecast would likely reappear brought on by the current expansion dying of old age and/or the unwinding of the mispricing and misallocation of assets wrought by another instance of failed Fed monetary policy.  Clearly that would all change if Trump/GOP were to achieve its promised fiscal program without running up the federal debt.

It is important to note that this forecast is made with a good deal less confidence than normal; so it carries the caveat that it will almost surely be revised.
                        The latest from Bill Gross (medium):

       The negatives:

(1)   a vulnerable global banking system.  Nothing new.

(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 regulatory element is unfolding as well if not better than anyone could have imagined.  Plus, his actions with respect to trade have been much less negative than I had feared.

On the other hand, Trump/GOP’s fiscal program is a mess. Despite repeated assurances than repeal and replace would be accomplished in reasonably short order, so far all we have is that narrative with little else to back it up.  Further, many had hoped that with the seeming demise of repeal and replace, the Donald/GOP would turn their attention to tax reform.  However, this week, Trump acknowledged that meaningful tax reform was impossible without the savings generated by repeal and replace because the math of a big tax cut simply doesn’t work without it.

Nevertheless, I do believe that Trump and the GOP congress will ultimately deliver healthcare reform, tax reform and some infrastructure spending legislation in some form; and that it will be a net positive for the long term secular growth rate of the economy.  But  it (1) is not apt to have nearly as big an impact as many of the dreamweavers would hope and (2) could get lost in the short term if the current economic expansion dies of old age/or is put to death by the Fed.

The bottom line here is that (1) deregulation is lifting our economy’s long term growth prospects, (2) announced trade positions are not the negative that I had feared, (3) but 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 secular growth but (4) the restraint on accomplishing aggressive tax and spending programs is not GOP harmony but math. 

(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.  

Thankfully, the Fed was on its own break this week.  Yellen did give a speech on Monday but added little to the narrative generated last week by the release  of the latest FOMC meeting’s minutes [it is giving serious consideration to begin shrinking its balance sheet]. 

Which leaves us with the question, will it start reducing its balance sheet if in fact, the economy is starting to weaken, as the latest data may be suggesting?  The answer, of course, is why wouldn’t it?  It has screwed up every single tightening process in its history.  Why ruin a perfect record? 

That said, you know that my concern is not the damage ending QE might do to the economy---QE did little to help it, so I don’t imagine that its reversal will be that disruptive.  But it does fit my thesis of asset price mean reversion.  Once investors realize that the Fed has again stimulated too much and deferred tightening for too long, the Markets which were the prime beneficiaries of QE will become the victims of its reversal.

The illusion of liquidity (medium):

The latest on the Chinese monetary policy (medium):

(4)   geopolitical risks: the troubles over Syria and North Korea were center stage this week.  Things went a bit better for the US in the latter situation.  Following Trump’s meeting with president Xi last weekend, the Chinese made some fairly aggressive verbal attacks on the North Koreans.  That makes sense because the Chinese have a lot to lose---possible major deployment of both offense and defensive weapons in Japan and South Korea.  And not being labelled a currency manipulator didn’t hurt. 

Unfortunately, a resolution to the Syrian problem appears a long way off.  Russia and the US spent most of the week in a war of words over whether there actually was a chemical weapons attack and if there was, who was responsible.  That is not that difficult to understand, since the Russians have everything to gain [construction of a major gas pipeline through Syria that would supply western Europe] defending the Assad regime.  Secretary Tillerson, Foreign Minister Lavrov and Putin did meet on Wednesday. The rhetoric in the following news conference got a bit testy; but it was refreshing to hear a Secretary of State do something other than pander.

On the gas attack; presented with no comment (medium):

In addition, for those morally offended by the civilian casualties from the gas attack, look at these numbers (medium):

All that said, barring a nuclear holocaust, history suggests that a breakout of hostilities is not that bad for either the economy or the Markets. (medium and a must read):

(5)   economic difficulties in Europe and around the globe.  This week, the global data flow improved:

[a] February EU industrial production disappointed; March UK inflation came in over the BOE’s target; March German economic conditions index and investor sentiment both rose.

[b] March Chinese auto sales were better than expected; March Chinese PPI and CPI were reported below estimates while March Chinese imports and exports were stronger than anticipated.

In sum, the eurozone economy continues to improve while the stats out of Asia were a bit more promising this week.  After some mixed stats last week, this keeps alive the chances that I could alter our ‘muddle through’ forecast.

            Bottom line:  the recent trend toward economic improvement seems to have stalled in the last four weeks.  I have no idea if this is a pause that refreshes or it marks the end of the economic effects of the post-election boost in sentiment.  Time will tell us. 

More importantly for the long term, the Donald’s drive for deregulation and improved bureaucratic efficiency is a decided plus; and as a result, I inched up my estimate of the long term secular growth rate of the economy.  In addition, a more reasoned approach to trade appears to be emerging which would remove a potential negative. 

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 further 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: weekly mortgage and purchase applications were up,

(2)                                  consumer: March retail sales and sales ex autos were below consensus; month to date retail chain store sales growth improved from the prior week; weekly jobless claims were better than anticipated; revised March consumer sentiment improved more than forecast,

(3)                                  industry: the March small business optimism index was slightly below expectations,

(4)                                  macroeconomic: March import prices were in line while export prices were higher than projections; March PPI and PPI, ex food and energy were weaker than estimates; March CPI and CPI, ex food and energy were below consensus..
The Market-Disciplined Investing

The indices (DJIA 20453, S&P 2328) continued to sink on Thursday, probably helped by the fact that after such an event filled week, traders wanted to reduce their risk over a long weekend.   Both again ended below the upper boundaries of their very short term downtrends. Volume declined; breadth deteriorated further.  The VIX (15.9) rose 1 ½ %, ending above the lower boundary of its very short term uptrend, above its 100 day moving average (now support), above its 200 day moving average for a fourth day (reverting to support) and in a short term trading range.  Complacency appears to have left the room.

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 {19350-21635}, [c] in an intermediate term uptrend {11936-24785} and [d] in a long term uptrend {5751-23390}.

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 {2263-2596}, [d] in an intermediate uptrend {2089-2693} and [e] in a long term uptrend {905-2591}.

The long Treasury rose on volume, remaining above its 100 day moving average (now support), below its 200 day moving average (now resistance), in a very short term downtrend and in a short term trading range.

GLD was up, closing above its 100 day moving average (now support), above its 200 day moving average (now resistance; if it stays there through the close on Monday, it will revert to support) and right on the upper boundary of its short term downtrend. 

The dollar increased, ending above its 100 day moving average (now support), below its 200 day moving averages (now resistance), below the upper boundary of its very short term downtrend and in a short term uptrend.

Bottom line: stocks moved steadily lower for a second day; although as I noted above, at least part of this decline was probably because traders wanted to reduce their risk in front of a long weekend.  Nevertheless, the Averages remain in a fairly tight three week trading range which has been characterized by intraday volatility that didn’t follow through to the close---reflecting, I think, a standoff between the bulls and bears.  Right now the weight of evidence (moving averages and major trends) is that it gets resolved in favor of the bulls. 

Unlike stocks, the VIX, gold, TLT and the dollar continue to challenge resistance/support levels, suggesting those investors are less positive on the economy/corporate profits than the stock guys.
Fundamental-A Dividend Growth Investment Strategy

The DJIA (20591) finished this week about 60.5% above Fair Value (12823) while the S&P (2344) closed 47.8% 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 (but with a negative caveat).  As you know, I recently raised our short term growth forecast based on the thesis that the rise in post-election sentiment would eventually be reflected in the hard data.  That is starting to look a bit iffy.  Given the difficulties that the Donald/GOP have had implementing its fiscal program, it wouldn’t be a surprise that companies/consumers may be retreating from earlier more ambitious spending programs.  Nevertheless, I am not reverting to our former outlook just yet.

On a long term basis, I feel like I am on firmer ground modestly raising the secular economic growth rate in our Models based on Trump’s good work at deregulation and the move toward a more free trade posture---this week backing down from ‘currency manipulator’ charges aimed at China. Assuming a continuing pro free trade tilt in policy, a major negative for economic growth will be eliminated.  

In addition, if Trump/GOP can successfully enact a fiscal program, I will likely raise the secular growth rate assumption again; although I have no thought on the order of magnitude.  However, I have made it clear that based on the budget math, I seriously doubt that the final product will be anywhere near as positive as many on the Street believe.

Not to be repetitious, but I want to be clear.  First, the improvement in the long term secular growth rate of the economy effects the potential for growth.  It increases my assumption about long term growth which impacts our Models.

 However, it has much less to do with the growth estimates for this year or next.  That forecast is more heavily impacted by cyclical forces.  For example, if the post-election pickup in economic activity is fading and I have to return to our prior forecast of recession/stagnation, the long term growth potential of the economy doesn’t change but it also does little to help.  The important factor at that point is that the excesses that occurred during what has been a record (in length) expansion are being reversed as the expansion dies of old age.  The point being that I can have a more optimistic outlook for  economic growth longer term and at the same time recognize that cyclical forces are working to slow the economy down short term.

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 (again, just for clarity’s sake, the economy can slow down due to old age and that would have nothing to do with unwinding QE.  The point being that the ending of QE wouldn’t make the slowdown any worse).  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 as well as a more rational approach to trade, I caution investors not to get too jiggy about the potential improvements coming in fiscal policy and the rate of any accompanying acceleration in economic growth and corporate profitability.  If that fails to materialize it will likely have detrimental effect on Street economic, corporate profits and Market expectations. 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.

The latest from Doug Kass (medium):

Bottom line: the assumptions in our Economic Model are beginning to improve as we learn about the new regulatory policies and their magnitude.  However, fiscal policies remain an unknown as well as their timing and magnitude.  I continue to believe that end results will be 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 assumptions are also changing as I raise our long term secular growth rate estimate.  This will, in turn, lift the ‘E’ component of Valuations; but there is a decent probability that short term this could be at least partially offset by 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.

DJIA             S&P

Current 2017 Year End Fair Value*              13200             1630
Fair Value as of 4/30/17                                  12864            1590
Close this week                                               20591            2344

Over Valuation vs. 4/30 Close
              5% overvalued                                13507                1669
            10% overvalued                                14150               1749 
            15% overvalued                                14793               1828
            20% overvalued                                15436                1908   
            25% overvalued                                  16080              1987
            30% overvalued                                  16723              2067
            35% overvalued                                  17366              2146
            40% overvalued                                  18009              2226
            45% overvalued                                  18652              2305
            50% overvalued                                  19296              2385
            55%overvalued                                   19939              2464
            60%overvalued                                   20582              2544
            65%overvalued                                   21225              2623
            70%overvalued                                   21868              2703

Under Valuation vs. 4/30 Close
            5% undervalued                             12220                    1510
10%undervalued                            11577                   1431   
15%undervalued                            10934                   1351

* 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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