Saturday, May 20, 2017

The Closing Bell

The Closing Bell


We are headed for the beach.  Be back 5/30.  As always I will have my computer with me and will stay abreast of Market action.  Any changes will be done via Subscriber Alerts.

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                                 19783-22726
Intermediate Term Uptrend                     18071-25785
Long Term Uptrend                                  5751-23836
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2311-2591
                                    Intermediate Term Uptrend                         2134-2738
                                    Long Term Uptrend                                     905-2741
                        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.   While sparse, the data flow this week was tilted to the positive side: above estimates: the May housing market index, month to date retail chain store sales, weekly jobless claims, April industrial production and the May Philly Fed manufacturing index; below estimates: April housing starts, weekly mortgage and purchase applications, the May NY Fed manufacturing index; in line with estimates: April leading economic indicators.

 However, the primary indicators were mixed:  April industrial production (+), May housing starts (-) and April leading economic indicators (0).  Given the overall positive weighting, I score the week a plus: in the last 85 weeks, twenty-eight were positive, forty-six negative and eleven neutral. 

On the political side, the last two weeks have been all about the Donald’s problems, many of which are self-imposed.  I am not going to speculate on his guilt or innocence.  For our purposes, the important factor is how these distractions impact the Trump/GOP fiscal program.  My conclusion is that the best case is that any policy changes will be delayed, likely into 2018.  However, if he is found guilty/complicit, the odds of any changes from here seem quite low.  

On the other hand, if all these issues are manufactured, this whole mess could be over quicker than many may think.  The question at that point would be, can Trump curb is mouth and attack style long enough not to bring another round of accusations.

The troubles with Syria and North Korea slid from the headlines.  Although clearly, they have not gone away.  My bottom line remains that while I can’t imagine either situation leading to anything more serious than threatening headlines, we have to be open to the chance of either or both of these situations going beyond a war of words. 

Overseas, the numbers keep improving in Europe.  So much so that I am taking it out of the ‘muddle through’ forecast for global growth---with the caveat that a major financial crisis in Italy could end that progress abruptly.

Bottom line: this week’s US economic stats were positive this week, though this has been the exception rather than the rule of late.  I continue to believe that the better economic momentum from the post-election Trump bliss is fading; and I suspect that his political troubles will only exacerbate this waning impulse.  Another week or so of poor numbers, I will likely return to our original short term economic forecast.

Longer term, I remain confident in my recent upgrading our long term secular growth rate by 25 to 50 basis points based on Trump’s deregulation efforts as well as his more reasoned approach to trade.  However, any further increase in that long term secular economic growth rate assumption stemming from enactment of his/GOP fiscal policy is now on hold.

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; though the odds of that have certainly slipped. 

 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 either 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.  

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 negatives:

(1)   a vulnerable global banking system.  Bank derivative portfolios remain at the center of this concern.  This week we received a report [which I linked to in Wednesday’s Morning Call] detailing the derivative holdings of the ‘too big to fail’ banks---$222 trillion.  To be fair, much of this exposure is hedged; we just don’t know how much.  We also don’t know the strength of the counterparties---meaning if one of the parties defaults, it can start a chain reaction.  Again, we have no idea where that could lead.  But that is the point, nobody, including the bank regulators know.  And that is a problem.

Meanwhile, another fraud and corruption suit is being brought against Deutschebank (medium):

And the Bank of China’s crackdown on speculators is having the expected effect---a likely surge in defaults (medium):

(2)   fiscal/regulatory policy.  Regrettably, in the last two weeks, the swamp has been all about presumed Trump infractions.  Whether or not he is innocent of all charges, the accompanying hysteria has brought Washington’s real job to a halt.  Meaning until the accusations are adequately addressed, the work on the Trump/GOP fiscal program is likely to go nowhere. 

On the downside, this means that reforms are not likely to be achieved in 2017; and the odds of them being accomplished in 2018 is probably tied to any finding of guilt or complicity of Trump in any of the multitude of charges.

On the upside, if there is no substance to the accusations, this crisis could be over sooner than many think.  That, in turn, could mean an increased likelihood of passage of the +Trump/GOP reform legislation.

      Friday afternoon development (short):

Until we have a better idea of how much time is going to be consumed by these going on’s, this also means any additional potential improvement in our long term secular economic growth rate assumption in our Models is on indefinite hold.  However, it in no way alters the recent changes made as a result of Trump’s actions on the regulatory front.  Further, the upcoming overseas trip is rumored to include a number of economic deals that would benefit the economy.

Finally, while I am not trying to make chicken salad out of chicken sh*t, you will recall that one of my concerns about the Trump fiscal agenda has been that it would add substantially to the deficit and debt.  If indeed that is [was?] going to occur, then gridlock is [was?] a positive alternative.  In other words, while a revenue neutral fiscal policy would be a plus, a major increase in the deficit/debt would be a negative.  We may never know what the actual policies would have ultimately looked like; but should they lead to more profligate spending, slowing down/reducing the size/eliminating this program could be a blessing in disguise.
                  Goldman on the likely timing and shape of fiscal policy (medium):

                  The latest from Nassim Taleb (medium):

(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.  

It was another quiet week for the Fed [thankfully]; though the lousy data from the last quarter notwithstanding, there is no indication that a June rate hike is any less likely. 

Ooops, news flash, Bullard says Fed should retain option for more QE.

You know my thoughts:

‘The risk here is that the Fed continues to tighten just as the economy rolls over in what would be a normal correction after eight years of expansion, albeit subpar.  As you know, I am not particularly concerned that about the economic consequences of the unwinding of a disastrous monetary experiment.  But such a move would likely (1) destroy the blind faith in the Fed by at least a portion of yet another new generation of investors and (2) reaffirm the stupidity of trusting the Fed to all the subsequent generations of investors that have already been f**ked enumerable times---my thesis that triggers the unwind of the massive mispricing and misallocation of assets.’

This threat is made all the worse by the [a] the recent crackdown on speculation by the Bank of China and [b] the odds of an ECB tightening as a result of the much improved outlook for the EU economy.

Meanwhile, the Bank of Japan keeps doing what it does best---buy everything in sight (medium):

What happens next? (short):

(4)   geopolitical risks: the troubles over Syria and North Korea haven’t gone away despite them being demoted to second page news.  The risks remain [a] in North Korea, when you are dealing with at least one nut case, the risk of some untoward event occurring is higher than normal and [b] in Syria, the risk of a faceoff with Russia. 

(5)   economic difficulties around the globe.  The European economic stats continue to improve to point that I am removing the continent from the ‘muddle through’ scenario.  Not that there are not risks; specifically from Italy, where the danger of a financial crisis remains.

[a] April UK CPI and PPI were higher than projected, while EU inflation rose in line {as I suggested above, the importance of this is the rising probabilities a monetary tightening by their respective central banks]; UK retail sales were up more than anticipated,

[b] first quarter Japanese GDP was up and better than forecast.

One more item to mention is the struggle within OPEC to hold together and   extend its as yet unsuccessful oil production cut agreement.   This, of course, is not a problem but a plus for the world’s economies, ex oil producers, of which the US is one.  Remember the impact of the last ‘unmitigated positive’ decline in oil prices.

In sum, the European economy continues to improve and has reached the point where I will take it off the negative factors list and out of the ‘muddle through’ thesis.  In addition, Japan is finally showing some signs of life; though it has a long way to go to convince me that it is no longer a negative.  Finally, there was no news on the Chinese economy this week.  Although the Bank of China continues its efforts to reduce speculation there which likely means a declining rate of economic growth.

            Bottom line:  the post-election sentiment inspired economic improvement seems to be fading.  As a result, a return to our prior short term economic forecast is a definite possibility. 

However, if Trump/GOP were to pull off healthcare reform, tax reform and infrastructure spending on a reasonable timely basis, I would suspect that sentiment driven increases in business and consumer spending would be positively affected; and more importantly, our long term secular economic growth rate assumption would almost certainly rise---with the caveat that it doesn’t result in a big increase in the national debt.

Of course that notion is now on hold until it becomes clearer how much substance is contained in the multiple allegations against the Donald.

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:

This week’s data:

(1)                                  housing: April housing starts were below consensus; weekly mortgage and purchase applications fell; the May housing market index was above expectations,

(2)                                  consumer: month to date retail chain store sales growth increased from its prior reading; weekly jobless claims fell versus projections of an increase,

(3)                                  industry: April industrial production was above forecast; the May NY Fed manufacturing index was very disappointing while the Philadelphia Fed index blew estimates away,

(4)                                  macroeconomic: April’s leading economic indicators were up, in line.

The Market-Disciplined Investing

The indices (DJIA 20804, S&P 2381) had a good day, finishing above their 100 and 200 day moving averages and the lower boundaries of uptrends across all major time frames---in other words, in solid uptrends.  And they still remained below those big Wednesday down gap openings which gives extra gravitational pull to the upside.  Volume fell; but breadth improved.

The VIX (12.0) declined another 18%.  It ended below its 100 day moving average, voiding Wednesday’s break and leaving it as resistance.  However, it still closed above its 200 day moving average for a third day (if it remains there through the close next Monday, it will revert to support) and Wednesday’s huge gap opening.
The long Treasury and gold were up while the dollar was down, all pointing to a weaker economy/lower rates.

TLT closed between narrowing distances its 100 and 200 day moving averages and the upper boundary of its short term downtrend and the lower boundary of its long term uptrend. 

The dollar finished below its 100 and 200 day moving averages, within a very short term downtrend and a short term trading range. 

GLD remained above its 100 and 200 day moving averages and within a short term trading range.

Bottom line:  it looks like the indices are about to close those Wednesday opening gaps down.  After that technical task has been satisfied, the question will then be, will they challenge their all-time highs.  At the moment, the answer seems to be yes; though I do think the burden is on the Market to prove that it can.  In the meantime, we have to assume that there is little danger of a trend reversal.
            This week in charts (medium):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (20804) finished this week about 61.1% above Fair Value (12906) while the S&P (2381) closed 49.2% overvalued (1595).  ‘Fair Value’ will likely be changing based on a new set of regulatory policies which has led to improvement in the historically low long term secular growth rate of the economy (though its extent could change as the affects become more obvious); but it still reflects the elements of a botched Fed transition from easy to tight money and a ‘muddle through’ scenario in Japan and China.

This week’s US economic stats, while few in number, were positive.  However, given the dataflow of the last two months, I am questioning my decision to raise our short term growth forecast based on the thesis that the rise in post-election sentiment would eventually be reflected in the hard data---which it did initially but has been fading.   Meaning a reversal in our outlook is on the table.

On the other hand, Europe’s economy has been improving sufficiently to discard the label of ‘muddle through’ and expect that it will have a positive impact on the US economy. Unfortunately, the Chinese government/central bank is making a meaningful effort to reduce speculation and that is having a dampening effect on liquidity in the financial system and economic growth.  That has the potential of also pushing China out of the ‘muddle through’ category, but to the negative side.  So at the moment, I am not altering the assumption on international economic growth in our Model.

In the political arena, the last two weeks have seen nothing related to the Trump/GOP fiscal program.  Indeed, the accusations mounting against the Donald will probably delay any implementation of their plan.  Plus, there may be more to come.  Further, if there is actually some fire in the midst of all the smoke, it may be impossible to get any reform legislation done ahead of the 2018 elections.  Three points:

(1)   if you believe that the post-election rally was in anticipation of a new fiscal/regulatory regime, then sooner or later, it seems logical that the lack thereof should lead to a downward adjustment in investor expectations, 

(2)   as I noted above, if the Trump fiscal program was going to lead to a dramatic increase in the deficit/debt, then its non-passage is a net plus,

(3)   finally, not that I think that the odds are high; but if the current political turmoil degenerates into a Watergate atmosphere, the current investor euphoria is apt to disappear quickly.  On the other hand, if the charges against Trump prove to be bulls**t, progress towards fiscal reform could get back on track faster than many now think.

Net, net, I think that the odds of fiscal legislation being delayed or destroyed have grown.  That means that I have put any thoughts of upgrading the assumptions in our Models on hold.
Of course, 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 also 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 begins to tighten.

Another must read article by Jeffrey Snider (medium):

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.   While I am encouraged about the changes already made in regulatory policy as well as a more rational approach to trade, that is not enough to alter the gross mispricing of assets.  Plus any increase in valuations stemming from enactment of the Trump/GOP fiscal agenda is now, at least temporarily on hold.   Finally, whatever happens, stocks are at or near historical extremes in valuation, even if the full Trump agenda is enacted; and there is no reason to assume that mean reversion no longer occurs.

Exuberance, expectations and gravity (medium):

A look at first quarter earnings (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, as this week’s developments indicate, 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 5/31/17                                  12906            1595
Close this week                                               20804            2381

Over Valuation vs. 5/31 Close
              5% overvalued                                13551                1674
            10% overvalued                                14196               1754 
            15% overvalued                                14841               1834
            20% overvalued                                15487                1914   
            25% overvalued                                  16132              1993
            30% overvalued                                  16777              2073
            35% overvalued                                  17423              2153
            40% overvalued                                  18068              2233
            45% overvalued                                  18713              2312
            50% overvalued                                  19359              2392
            55%overvalued                                   20004              2472
            60%overvalued                                   20649              2552
            65%overvalued                                   21294              2631

Under Valuation vs. 5/31 Close
            5% undervalued                             12260                    1515
10%undervalued                            11615                   1435   
15%undervalued                            10970                   1355

* 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.

1 comment:

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