Saturday, June 3, 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 (revised)

Real Growth in Gross Domestic Product                      -1.25-+0.5%
                        Inflation                                                                         +.0.5-1.5%
                        Corporate Profits                                                            -15-0%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                                 19934-224966
Intermediate Term Uptrend                     18212-25461
Long Term Uptrend                                  5751-24198
                        2016    Year End Fair Value                                   12600-12800

                        2017     Year End Fair Value                                   13100-13300

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2330-2632
                                    Intermediate Term Uptrend                         2153-2926
                                    Long Term Uptrend                                     905-2763
                        2016   Year End Fair Value                                      1560-1580
2017 Year End Fair Value                                       1620-1640         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          58%
            High Yield Portfolio                                     55%
            Aggressive Growth Portfolio                        55%

The Trump economy is providing an upward bias to equity valuations.   The data flow this week was negative, again: above estimates: the May ADP private payroll report, the May Dallas Fed manufacturing index, the May Chicago PMI and the May ISM manufacturing index; below estimates: April pending home sales, weekly mortgage and purchase applications, the March Case Shiller home price index, May consumer confidence, May and month to date retail chain store sales, May light vehicle sales, weekly jobless claims, May nonfarm payrolls, the May Markit PMI, April construction spending and the April trade deficit; in line with estimates: April personal income and spending.

 In addition, the primary indicators were negative:  April construction spending (-), May nonfarm payrolls (-) and April personal income and spending (0), making this week an easy call--a minus: in the last 87 weeks, twenty-eight were positive, forty-eight negative and eleven neutral. 

As a result, I am resetting our short term economic forecast back to my prior estimates (see above).  This, however, has no impact on the improvement in the longer term secular economic growth rate potential stemming from Trump’s regulatory reform.

Overseas, the numbers keep improving in Europe (recall that it is no longer part of the ‘muddle through’ forecast for global growth).   On the other hand, the other major world economies continue to struggle.  The net effect should be a plus for the short term growth rate, though I would like to have more clarity on the Chinese economy before I make any additional changes in our forecast

Bottom line: this week’s US economic stats were negative again this week, prompting a reset in our forecast back to our prior stagnate growth outlook.  Longer term, I remain confident in my recent upgrading our long term secular growth rate assumption 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 has seemingly lost its post-election Trump momentum meaning that our former recession/stagnation forecast is back as the current expansion seems to be dying of old age.

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.
                        Update on big four economic indicators (medium):

       The negatives:

(1)   a vulnerable global banking system.  Good news and bad news this week.  [a] the auto and student loan markets in the US continue to deteriorate while [b]  the Italian bank [Monte Paschi] at the center of the troubled Italian financial system appears to have reached an agreement on a bailout.

We hear little about bank fraud in China; but read this (medium):

(2)   fiscal/regulatory policy.  There was little progress on the Trump/GOP fiscal reforms this week.  Regrettably, that is likely to remain so as the dems and the media continue to focus on the Donald’s alleged infractions and he only makes matters worse by his chronic foot in the mouth disease.  In short, the work on the Trump/GOP fiscal program is likely to go nowhere anytime soon. 

Until we have a better idea of how much time is going to be consumed by these going’s on, this also means any additional potential improvement in our long term secular economic growth rate assumption in our Models is on indefinite hold. 
However, all is not bad news.  Trump’s demands that the NATO countries share the costs of their defense and the withdrawal from the Paris accord are, economically speaking, positives.  To be clear, this opinion has nothing to do with science or political/social policy.  It is an observation that the less money the US has to spend on defending NATO and funding climate change projects in the third world, the more money there is to spend on our own problems and/or cut spending altogether. 

As you know, I believe that the US has reached the point in which the debt and deficit are acting as drags on our economic growth.  This country does not have an endless supply of funds to finance all the worthy projects in the world.  We simply have to take care of ourselves first; then worry about others.  In our current state of financial affairs, giving money to third world countries to affect their own climate change efforts is like you or I going to the bank and borrowing money to contribute to the United Way.  It might be a worthy cause but it is, in my opinion, senseless to donate ourselves into poverty.

And speaking of deficit spending, based on the same notion about deficit/debt impact on economic growth, if any new GOP tax or spending measures would lead to further increases in the deficit/federal debt, then I would not score them as a plus for growth; and depending on their magnitude could very well lower our long term secular growth rate assumption.  In that case, gridlock would be a positive alternative scenario.

Adding to this problem is a decline in tax receipts [raising the obvious question, how can consumer incomes and corporate profitability be rising and tax receipts falling?]

(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.  

The FOMC released its latest Beige Book this week [I mistakenly referred to it as FOMC minutes in Thursday’s Morning Call].  However, the narrative was still as I described: the economy is doing fine; except that there are problems; but no sweat, we are raising interest rates anyway. 

Jeffrey Snider on the Beige Book (medium and a must read):

BOJ and ECB balance sheets now bigger than the Fed’s (short and a must read):

‘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.’

(4)   geopolitical risks: the troubles with Syria and North Korea haven’t gone away.  This week North Korea and the US engaged in a missile firing contest.  And in addition to the normal daily violence in the Middle East, there were lethal bombings in the UK and Afghanistan.  While I believe that the risks of open warfare with North Korea or a confrontation with Russia in the Middle East are small, the consequences of either are significant.

(5)   economic difficulties around the globe.  The European economic stats continue to improve which will almost surely be a plus for the US economic growth.  However, Japan and China remain a problem as economic weakness in both countries persists.

[a] April EU inflation was slightly less than anticipated; May UK and EU manufacturing PMI’s were better than expected,

[b] May Chinese manufacturing PMI was flat while the nonmanufacturing PMI was better than estimates.

Oil continues to be a factor in global economic health---lower prices having proven to be a negative for growth, at least in the US.  OPEC is still struggling to maintain discipline in its production cut agreement, which is not working out too well.  There are signs of cheating within OPEC and increases in production among nonmembers.  Remember the impact of the last ‘unmitigated positive’ decline in oil prices.

In sum, the European economy showed further improvement, Japan may be showing signs of life though there was no data to that effect this week and the Bank of China continues its efforts to reduce speculation amidst signs of a declining rate of economic growth.  Overall, the better numbers out of Europe makes this factor less negative.

            Bottom line:  the post-election sentiment inspired economic improvement seems to have faded into the mist.  As a result, our near term forecast returns to our prior weaker outlook.

However, if Trump/GOP were to pull off a (near) revenue neutral 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 return; and more importantly, our long term secular economic growth rate assumption would almost certainly rise.

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 and foreign charity should support that revision. 

The Market-Disciplined Investing

The indices (DJIA 21206, S&P 2439) continued their upward moves with the Dow closing in on its former high (21228)---this pin action on a day with a very poor nonfarm payroll number.  That suggests to me that bad news is still good news, which strengthens the case that the Dow will most likely successfully challenge its former high.  If that occurs, there is little resistance between current price levels and the upper boundaries of the Averages’ long term uptrends---now circa 24198/2753.   Volume rose; while breadth improved.

The VIX (9.8) slipped again, ending below the lower boundary of its intermediate term trading range for the second day (if it remains there through the close next Tuesday, it will reset to a downtrend) and also below the lower boundary of its long term trading range (if it remains there through the close Thursday, it will reset to a downtrend).
The long Treasury was up 1 1/8 %, reflecting that lousy employment report (weak economy, low rates).  It ended above its 200 day moving average (if it remains there through the close next Wednesday, it will revert to support) and is closing in on the upper boundary of its short term downtrend.  If that barrier is successfully breached, it should lead to a sizeable move to the upside. 

The dollar fell 0.5%, mirroring TLT’s move but indicating that the dollar traders also agree with the weak economy/low interest rate scenario.

GLD rose 0.75%, closing above its 100 and 200 day moving averages, in a very short term uptrend and is nearing the upper boundary of its short term trading range.

Bottom line:  TLT, UUP, GLD investors all seem to concur that the weak jobs number is pointing to slower growth/lower rates.  I am not sure what stock investors believe other than that every day is Christmas.  The indices are close to a harmonious break above their former highs, opening the door to a move to the upper boundaries of their long term uptrends. 

Fundamental-A Dividend Growth Investment Strategy

The DJIA (21206) finished this week about 63.7% above Fair Value (12948) while the S&P (2439) closed 52.4% overvalued (1600).  ‘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.

The US economic stats have lost their post-election high. In addition, while the EU economy is improving, the Japanese and Chinese economies continue to flounder.  At the momentum, I am unsure of the overall net effect of the global economy on our own.  As a result, I am returning our economic forecast to our prior less positive economic outlook.  If I am correct that means Street forecasts will begin declining.  The question is when; and more important from a Market standpoint, given investor proclivity for interpreting bad news as good news, whether they will even care.  I can’t answer that latter issue except to say that someday, bad news will be bad news; and mean reversion will likely occur.

In the political arena, the Donald continues to do what is in his power to bring reform, specifically his deregulation efforts as well as pulling the US back from being a bottomless purse for the rest of the world’s problems.  While the effects of these moves are of a longer term nature, they do impact the secular growth rate potential.

Also of a long term character, it seems likely that the accusations mounting against the Donald will probably delay any implementation of his/GOP fiscal reforms---irrespective of whether he is guilty or not.  However, if indeed 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. 

            That said, I just want to reemphasize that if a taxing/spending program were to be enacted that was not near revenue neutral, I think that the outcome for the economy long term would be negative.  So gridlock may not be as negative as many may 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. 

The point of all this being that I believe Street enthusiasm for a significant improvement in the long term growth prospects of the US economy is certainly premature and most likely wrong.  This will probably result in the eventual lowering of Market expectations for growth as well as the discount factor it places on that growth.
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.

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 and our global commitments 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.

Bottom line: the assumptions on long term secular growth in our Economic Model are beginning to improve as we learn about the new regulatory policies and their magnitude.  On the other hand, 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 potential ‘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 want to own cash in my Portfolio and 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 6/30/17                                  12948            1600
Close this week                                               21206            2439

Over Valuation vs. 6/30 Close
              5% overvalued                                13595                1680
            10% overvalued                                14242               1760 
            15% overvalued                                14890               1840
            20% overvalued                                15637                1920   
            25% overvalued                                  16185              2000
            30% overvalued                                  16874              2080
            35% overvalued                                  17479              2160
            40% overvalued                                  18127              2240
            45% overvalued                                  18774              2320
            50% overvalued                                  19422              2400
            55%overvalued                                   20069              2480
            60%overvalued                                   20716              2560
            65%overvalued                                   21364              2640

Under Valuation vs. 6/30 Close
            5% undervalued                             12289                    1520
10%undervalued                            11653                   1440   
15%undervalued                            11005                   1360

* 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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