Saturday, June 10, 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                                 20039-22549
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                                     2340-2642
                                    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 thin and mixed: above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, the April JOLTS report, weekly jobless claims and revised first quarter nonfarm productivity; below estimates: the May Markit services PMI, the May ISM nonmanufacturing index, April factory orders, April wholesale inventories and sales and April consumer credit; in line with estimates: none.

 The primary indicators were also neutral:  revised first quarter nonfarm productivity (+), April factory orders (-).  I score this week a neutral: in the last 88 weeks, twenty-eight were positive, forty-eight negative and twelve neutral. 

Overseas, the numbers out of Europe were directionless, the Japanese stats remain terrible and Chinese data continues to improve (but remember, these guys lie a lot; plus the government bond yield curve is flattening, usually a sign of an impending recession). There is nothing here to warrant a change in our forecast of an improving economy in Europe and a ‘muddle through’ scenario for the rest of the world.  As I noted last week, the better outlook in Europe should have a positive impact on our short term US economic growth assumption, though I have held off making a formal change to date.

The main political event this week was the Comey testimony which while entertaining to watch and providing enough material to get panties in a wad for both parties, in the end provided little evidence of an impeachable offense.  The question is, how long can the dems delay/prevent the enactment of the Trump/GOP fiscal plan pursuing their ‘impeachable offense’ narrative?  I don’t know the answer to that; but it is likely to be longer than envisioned in the original game plan.  That said, the house passage of Dodd Frank reform this week is a hopeful sign at least some progress will be made.

Bottom line: this week’s US economic stats were mixed this week, neither supporting nor countering our 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.  That conviction was bolstered this week by actions in the EU on defense and negotiations with Mexico on the sugar trade.  Nonetheless, any further increase in that long term secular economic growth rate assumption stemming from enactment of the Trump/GOP fiscal policy is still 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 are uncertain. 

 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.

       The negatives:

(1)   a vulnerable global banking system.  One piece of good news this week: it was reported that a Spanish bank was on the verge of bankruptcy; but almost immediately a larger Spanish bank bought it.  That it happened so quickly is especially positive.

(2)   fiscal/regulatory policy.  There was some progress on the Trump/GOP fiscal/regulatory reforms this week. 

[a] the house passed a Dodd Frank reform package.  While undoubtedly a step forward {i} it still has a long journey ahead.  The senate has to pass its version, then the bills have to be reconciled and {ii} of all the needed reforms, this was last on my list of things to do.  As you know, I believe that the big banks deserve all the regulation they get.

Though this is still a plus (medium and a must read):

[b] the NATO countries released a statement that they need to take more responsibility for their own defense.  Plus Mexico and the US reached an ‘agreement in principle’ to alter the way sugar is traded as a precursor to a larger review of NAFTA.  While the narratives in both were vague, it, nonetheless, suggests that Trump’s drive to remove the US as patron of last resort for the world’s security and happiness is having an effect and that is good news for US taxpayers {hopefully}.

On the other hand, internal GOP decent and the dems efforts to block all Trump/GOP fiscal reforms will hamper enactment and chew up time.  The latter is made all the worse by the constant stream of alleged infractions by the Donald and his incessant combative and factually inaccurate tweets.  And let’s not forget, there is still a special prosecutor out there and who knows what he will turn up.

In short, I am unsure about the speed with which the Trump/GOP fiscal program can progress.  Until we have a better idea of how much time is going to be consumed by the aforementioned goings on, any additional potential improvement in the long term secular economic growth rate assumption in our Models based on fiscal progress is on hold. 
Finally, I believe that the US has reached the point in which the debt and deficit are acting as drags on our economic growth. A corollary to that is that any tax reform or infrastructure programs have to be, at least, near revenue neutral in order for them not cause more economic damage than they are intended to cure. The point being that, in my opinion, while revenue neutral reform maybe a plus for the economy, it would not be a magic elixir that will return the secular economic growth rate to prior highs.
(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.  

As Christine Jorgensen once said, ‘it won’t be long now’.  In this case, I am referring to next week’s FOMC meeting.  Odds still favor a rate increase, the numbers be damned.

Credit markets are screaming stagnation (medium):

‘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.’

In other markets,

[a] at its meeting this week, the ECB followed the Fed’s oft used Alfred Hitchcock strategy---talk up the economy {it raised its growth rate forecast for EU GDP for 2017, 2018 and 2019, cut its inflation outlook for the same period} and then leave QE unchanged.  In short, the ECB and BOJ continue to supply lots of liquidity to the markets in an attempt to postpone the inevitable,

[b] despite some encouraging numbers from the Chinese economy, their bond yield curve is starting to invert---a sign of tightening monetary policy and a precursor to recession.

(4)   geopolitical risks: the troubles with Syria and North Korea haven’t gone away.  But they had to share the stage with other global developments this week including[a]  a schism in the Gulf OPEC nations; with Qatar being called out for its support of ISIS and other terrorist groups, [b] a terrorist attack in Iran of all places and [c] yet another attack in England. 

While I don’t want to minimize the significance of the latter, I do think the prior two are even more so.  Remember that an integral component of the Middle East violence is the long conflict between the Sunni and Shi’a sects of Islam.  They have hated each other for centuries and it has often erupted in to warfare.  This sectarian strife is a big part of the problem achieving real peace in Iraq.  It is also part of the motivation of the Saudi’s and others [Sunni] in attempting to punish Qatar [Shi’a] whom they have often accused of fomenting trouble within their Shi’a minorities.  And it appears that the Iranian [Shi’a] attacker was a member of ISIS [Sunni].

The whole point of this is that if the Sunni/Shi’a conflict breaks out into open warfare in the Middle East, it will make the Syrian conflict look like an extended session of laser tag.  And we then won’t be talking about what an ‘unmitigated’ positive lower oil prices are.

Meanwhile, back at the ranch,

[a] here is the latest from Syria (medium):

[b] the new president of South Korea declined to accept the US offer of an anti-ballistic missile system while North Korea set off a fireworks display of missile launches.

(5)   economic difficulties around the globe.  The European economic stats were mixed this week [though I continue to view the EU as a source of strength for the US and global economies], China improved [it said] and Japanese continues to bring up the rear.

[a] the May EU Markit composite PMI was unchanged; the May UK services PMI was worse than anticipated,

[b] May Chinese services PMI was better than expected; the May Chinese trade numbers were very strong; May Chinese CPI was in line while PPI was below forecasts; however, it is worrisome that the yield curve is flattening---a phenomena that generally proceeds recession; first quarter Japanese GDP grew less than expected.

[c] the World Bank forecast 2017 global growth of 2.7% and for 2018 2.9%

Oil continues to be a factor in global economic health.  It is being torn directionally speaking, by the aforementioned dust up in the Gulf States, on the one hand, and by rising inventories [meaning either cheating by OPEC members or rising production from non-OPEC countries or declining demand or all of the above] on the other.  At the moment, higher inventories [lower prices] is trumping fears of war in the Gulf States [higher prices].  Since energy is a major component of production, its price usually has a significant impact on economic growth; and lower prices have proven not to be an ‘unmitigated positive’. 

And, the Street continues to slash its price expectations.

In sum, the European economy is out of the woods.  China and Japan remain in the ‘muddle through’ scenario.

            Bottom line:  our near term forecast has returned to the 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.  Unfortunately its fate is uncertain given the antics of our political class.

For the long term, the Donald’s drive for deregulation and improved bureaucratic efficiency is a decided plus.  As you know, 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 21271, S&P 2431) turned in a very conflicting and confusing pin action on Friday.  The Dow closed above its former high.  It needs to remain there for two more days to confirm the break but it clearly is setting up to reverse its recent divergence in trend with the S&P.  That suggests momentum to the upside could be starting to assert itself. 

On the other hand, the S&P experienced a much more volatile day.  Indeed, it created an outside down day (its Friday high was higher than Thursday’s high, its Friday low was lower than Thursday’s low and it ended the day below Thursday’s close).  In technical terms that points to a change in upside momentum and move to the downside. 

So the bottom line is we have traded one technical issue (divergent trends) for another (an outside day for the S&P).  I still think that the move up is not over but the technical outlook is just as uncertain today as it was yesterday.  Volume was up and breadth was positive.

The VIX (10.7) also had an outside day but to the upside, voiding Thursday’s break of the lower boundary of its intermediate term trading range and remaining above the lower boundary of its long term trading range.   However, it is still below its 100 and 200 day moving averages and in a short term downtrend.
The long Treasury was down slightly, closing out a down week and leaving it below its 200 day moving average but above its 100 day moving average and in a very short term uptrend.  The gap between the upper boundary of its short term downtrend and lower boundary of its long term uptrend continues to narrow.

The dollar rallied, ending an up week but nothing disturbed its overall negative chart---ending in a very short term downtrend and below its 100 and 200 day moving averages.

After failing to break above the upper boundary of its short term trading range on Wednesday, GLD fell further, closing below the lower boundary of its very short term uptrend for a second day, negating that trend.  It finished above its 100 and 200 day moving averages and the 100 day moving average is about to cross above its 200 day moving average which is usually a positive technical signal.  However, this chart is getting a bit ugly.

Bottom line: next week should be interesting given the indices’ unusual pin action on Friday.  As I noted above, I think the assumption has to be that the momentum remains to the upside.   However, the outside day of the S&P coupled with the fact that investors in bonds, gold and the dollar seemed unimpressed with the better economy scenario, keeps open the possibility that we could be looking at a change of direction in equity prices.  As always, follow through is key.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (21271) finished this week about 64.2% above Fair Value (12948) while the S&P (2431) closed 51.9% 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; and I have returned our short term economic forecast to its less positive predecessor. While the better numbers out of Europe should add something to that growth rate, I am going to wait to see if the rest of the world follows suit before making any additional changes.

 If I am correct about the economy slowing short term 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 (except to shut up) 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 the latter moves are of a longer term nature, they did start to show some results this week as the EU acknowledged that it had to take more responsibility for its own defense and Mexico ‘agreed in principle’ to the start of a process to renegotiate portions of NAFTA.  In addition, the house passage of Dodd Frank reform is the first concrete step in fiscal reform though it remains a long way from becoming law.

On the other hand, the dems are doing everything in their power including generating a barrage of (as yet undocumented) accusations against the Donald to delay any implementation of his/GOP fiscal reforms.  I am unsure of how successful they will be.

            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 reform legislation being delayed are high; and that means that I have put any additional of upgrading the long term secular growth rate assumption 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.
Muddling in economic darkness (medium and a must read):

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 remains in question.  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.

What to do now (short):

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                                               21271            2431

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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