Saturday, August 5, 2017

The Closing Bell

The Closing Bell

8/5/17

We are off in search of cooler temperatures.  Back on 8/14.

Statistical Summary

   Current Economic Forecast
                       
2016 actual

Real Growth in Gross Domestic Product                          1.6%
Inflation (revised)                                                              1.6%                     Corporate Profits (revised)                                                     4.2%

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                                 20625-23139
Intermediate Term Uptrend                     18586-25837
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                                     2413-2715
                                    Intermediate Term Uptrend                         2208-2982
                                    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                          59%
            High Yield Portfolio                                     55%
            Aggressive Growth Portfolio                        55%

Economics/Politics
           
The Trump economy is providing an upward bias to equity valuations.   By volume, the data flow this week was weighed to the positive: above estimates:  June pending home sales, month to date retail chain store sales, the July ADP private payroll report, weekly jobless claims, July nonfarm payrolls, July factory orders, the July Markit manufacturing and services PMI, the July ISM manufacturing index, the Dallas Fed manufacturing index and the June trade deficit; below estimates: weekly mortgage and purchase applications, June personal income, July light vehicle sales, July retail chain store sales, June construction spending, the July ISM nonmanufacturing index, the July Chicago PMI; in line with estimates: June personal spending.

Still, the primary indicators were slightly negative: June personal income (-), June construction spending (-), July retail chain store sales (-), June personal spending (0), July factory orders (+) and July nonfarm payrolls (+).    Given this week’s data end up basically mixed---stronger overall data, but weaker primary indicators---I score this week a neutral: in the last 95 weeks, twenty-nine were positive, fifty-two negative and fourteen neutral. 

Overseas, the numbers were upbeat with more good news out of Europe.  That has been a good news story of late. 

On fiscal policy, little was done.  The house is already on summer break, the senate left yesterday.  However, the flow of promises didn’t abate.  We are being assured of tax reform and infrastructure spending when our ruling class returns in the fall.

Two other items worth mentioning:

(1)   trade sanctions have become the most popular weapon of choice in dealing with adversaries: congress sanctions Russia, Trump sanctions the Venezuelan president and threatens sanctions against China.  Penalties may be justified and sanctions may work.  But I worry about overusing trade sanctions as a political bludgeon because it could lead to escalating trade wars.  History [Smoot Hawley] has shown us that is not a plus for economic growth.

(2)   special counsel Mueller has empaneled a grand jury.  This all the potential gripping the political and chattering classes with such force that it could likely not only delay/deter enactment of any of the Trump/GOP fiscal plan but also could lead to serious domestic turmoil.  This is not a forecast; it is a concern.

Bottom line: this week’s US economic stats were mixed, confirming the pattern for the last 18 months---the economy struggling to keep its head above water.  Even so, most of the securities indices reacted to Friday’s jobs number as though it were a clarifying datapoint, pointing to a stronger economy/higher interest rates.  I would counter that employment is a lagging indicator; so its value as a sign of a trend change is more likely to be as an inverse versus a coincident/leading marker.  In other words, strong employment is more likely the sign that an expansion is nearer its end than its beginning.  Supporting that notion is the weekly score I record every week which has given no sign that the economy is improving 

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.  However, the DC fascination with trade sanctions is turning an initial positive into a negative.  In addition, 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 as they struggle to get anything done.

Our (new and improved) forecast:

A 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.
                                               

                        Update on big four economic indicators.

       The negatives:

(1)   a vulnerable global banking system.  

Wells is at it again (medium):


EU banking system dysfunction gets even worse (medium):

US banks now lobbying to lower capital requirements (medium):

In spite of the freebee they get from the Fed (medium):

(2)   fiscal/regulatory policy.  This week: 

[a] with the house on summer break, little was accomplished on the legislative front or will likely get done in the next two months with the senate leaving for its summer break.  That didn’t keep the GOP from running out spokesperson after spokesperson assuring us that tax reform and infrastructure spending will be enacted by year end.  We can only hope---as long as they don’t bust the budget wide open in the process

[b] it also didn’t mean that the Donald was unoccupied.

{i} first, Trump signed the Russian sanctions bill passed earlier by congress.  As you know, I believe that the Russian weren’t guilty of anything that the US hasn’t done.  I am not suggesting that they get off scot free; but with the global economy limping along at best, the last thing it or the US needs in a trade war (see below).  Unfortunately, Trump was trapped into signing this as a result of his Russian connection/Comey firing problems,

{ii} Trump finally decided to take action against the Chinese on the issue of theft of American intellectual property---he appointed a group to study the issue and accompanied it with a threat of trade sanctions.  This is one of those issues in trade where I think that the Chinese pirating is pretty well known, generally agreed upon and costly to the US---one of our biggest exports is technology/technology related products.  Hence, I think that this move is justified.  The Chinese verbally reacted quite negatively; though we will have to wait for what they will do. 

All this said, if these actions prompt some sort of trade war, that is not going to be a plus for global economic growth; and ultimately could impact our economic outlook.

{iii} further, Trump took action on the immigration front, introducing a bill that radically changes our law.  On the whole, it seems a good place to start congressional negotiations.

        Counterpoint:

[c] meanwhile, below the radar, Trump is making a mark on our judicial system---which may be just as important as tax reform.


(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 Fed was quiet this week; though in the Treasury Borrowing Advisory Committee’s [an advisory body to the Fed] latest report, it outlined how disruptive the Fed’s balance sheet normalization is apt to be.  The Fed really didn’t need to be told that; their actions have shown that they know the problem that they have created.  But now they are on notice---and with no good alternatives.

The Bank of England met on Thursday, leaving monetary policy unchanged and lowering its forecast for 2017 and 2018 GDP growth.  That makes it unanimous.  QE for everyone.

(4)   geopolitical risks: this matter is starting to make me nervous. 

[a] first, the US imposes sanctions on the Russian for alleged interference in our elections and their aggression against Ukraine.  I don’t understand sticking your finger in the Russian’s eye when {i} the US has not only interfered in countless elections but instigated the assassination attempts of political leaders (think Castro, Diem) and {ii} Russia was responding to a CIA instigated coup of a duly elected pro-Russian president in Ukraine.  I am not suggesting that we allow Russia to do as it pleases.  But to antagonize them then feign outrage at their reaction is not productive or in the long term interest of peace or trade.

[b] second, North Korea is run by a punk and his cabal.  Yes, he has nukes; and yes, we need to be sure that he understands that an attack on the US means certain annihilation of his country.  But ramping up public hostility, in my opinion, makes it more likely that North Korea will make a mistake that puts the US in greater risk than it otherwise would be.

I am not trying to fear monger war; but I do think that Trump’s aggressive attitude toward foreign opposition is overdone and increases the risk of a costly misstep.

(5)   economic difficulties around the globe.  This week, the stats continued upbeat out of Europe and mixed out of China.

[a] the July EU and UK manufacturing PMI’s were above forecasts; but the Bank of England lowered its 2017/2018 GDP growth estimates,

[b] the July Chinese manufacturing and services PMI’s were below estimates; but the July Caixin services and manufacturing PMI’s, {another measure of the Chinese economy} were better than forecast.
               
Oil remains a factor in global economic health and its price continued its roller coaster ride.  This week, {i} the Gulf States doubled down on the sanctions against Qatar and {ii} chaos escalated in Venezuela as Trump imposed sanctions (this word is getting far too much use of late) on the country’s president. The point here is that [a] since energy is a major component of production, its price usually has a significant impact on economic growth, [b] I don’t think that the future for oil prices is all that clear and [c] lower prices have proven not to be an ‘unmitigated positive’. 

In sum, our outlook remains that the European economy is out of the woods while China is struggling to do the same.  My belief is that this will eventually positively impact the US economy.

            Bottom line:  our near term forecast is that the US economy is stagnating despite, an improved regulatory outlook and a now growing EU economy. These two factors should have a positive impact on US growth though there is scant evidence of it to date. Further, if Trump/GOP were to pull off a (near) revenue neutral healthcare reform, tax reform and infrastructure spending on a reasonably timely basis, I would suspect that sentiment driven increases in business and consumer spending would return.  On the other hand, whether justified or not, the Donald’s recent actions against Russia, China and Venezuela increase the likelihood of some sort of trade war.  I needn’t remind you that one of the major factors causing the Great Depression was the institution of the Smoot Hawley trade barriers. 

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 because of it. 

The Market-Disciplined Investing
         
  Technical

The indices (DJIA 22092, S&P 2474) were back in sync yesterday, largely on a better than expected jobs report (stronger economy, higher rates).  Volume was down.  Breadth was mixed but remained strong and within overbought territory.  The upward momentum as defined by the Averages’ 100 and 200 day moving averages and uptrends across all timeframes remains intact.  At the moment, technically speaking, I see little, except for the VIX, to inhibit their challenge of the upper boundaries of their long term uptrends---now circa 24198/2763. 

The VIX (10.0) fell 4 %.  It finished above back below the lower boundary of its former intermediate trading ranges but is still above the lower boundary of its former long term trading range.  As you know, I reset these trends to down but raised the question as to whether the VIX had made some kind of bottom.  I think that it remains a debatable point as the VIX continues to vacillate above and below those former trading range boundaries.

The long Treasury declined, but ended above its 100 and 200 day moving averages (both support), the lower boundaries of its short term trading range and its long term uptrend.  That is a lot of support.  So unless TLT starts breaking those support levels, I am assuming that Friday’s soft price performance is not something about which to be concerned.
           
The dollar popped to the upside, but still closed in a short term downtrend and below its 100 and 200 day moving averages.

 GLD was down, finishing below the lower boundary of its very short term uptrend but remained above its 100 and 200 day moving averages (both support). 

Bottom line: all the indicators responded as would be expected to the strong nonfarm payroll number and its economic implications (stronger economy, higher interest rates): (1) all the equity indices were up; of course, the Dow has been reflecting that scenario all along and (2) TLT and GLD were down and the dollar up.

As I often note, one day does not a trend make.  Plus, the only sign of any possible trend reversal was GLD’s falling below the lower boundary of its very short term uptrend.  I await follow through before considering that the ongoing divergences have been resolved.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (22092) finished this week about 69.5% above Fair Value (13032) while the S&P (2476) closed 53.7% overvalued (1610).  ‘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 effects 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 continue to point to a weak economy.  If I am correct about the economy slowing/stagnating, short term that means Street economic growth 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.

With the house already on summer break and senate leaving this weekend, not much is going to get done legislatively.  But Washington remains a busy place.  First, both Trump and GOP senators are out promising that tax reform and infrastructure spending are being hammered out among congressional leadership and that they will be much easier to pass than healthcare reform.  OK.  I hope that is right. 

But the general atmosphere in DC is one of extreme acrimony.  And it is going to get worse, if all the investigations into Trump’s Russian connection and Hillary’s emails gain momentum.  I am not saying tax reform and infrastructure spending won’t occur.  I am just pointing out that the normally ugly legislative process may be a bit more ugly if the aforementioned investigations lead to charges. That would not be a plus for investor sentiment.

In addition, sanctions were flying right and left---Congress enacting Russian sanctions and Trump imposing sanctions on the Venezuelan president and threatening more to come as well as instituting actions that could lead to sanctions against the Chinese over the theft of US intellectual property.  To be clear, there is a decent rationale for all of these actions; and it could be that they will have the desired effect on each one’s behavior.  But if they don’t, what then? 

What bothers me is that combined, they suggest a pattern by our political class that sanctions are a great tool to use to impose pain against any country that doesn’t act in what they believe is an acceptable manner.  Singularly, that is probably right.  I am worried about the collective impact; that is, if a single party retaliates, it is not apt to affect us all that much.  However, getting at odds with both the Russians and the Chinese could have a cumulative impact.  Further, the Europeans are upset about our actions against the Russians.  So add them to the list.  The point is that we can’t keep upsetting trade relations with multiple parties because cumulatively it could prove economically painful for us.  Don’t forget that one of the causes of the Great Depression was the passage of the Smoot Hawley tariff bill.   And don’t forget the subsequent Market’s pin action.

Finally, the central banks continue to confuse, obfuscate and pursue a policy that has destroyed price discovery---and it is being done not to have some potential positive effect on the economy, but to avoid a Market hissy fit.  Not something that I believe is in the best long term interests of the economy or the Markets.    As you know, I have long time believed that the loss of faith in or the dismantling of QE will result in correcting the mispricing and misallocation of assets; and that most assuredly will not be a plus for equity prices.

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, fiscal policy remains a mess.  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.  Plus, there is a tiny ray of hope that fiscal policy could make progress though its timing and magnitude are unknown.  I continue to believe that the 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 8/31/17                                  13032            1610
Close this week                                               22092            2476
Over Valuation vs. 8/31
             
55%overvalued                                   20199              2495
            60%overvalued                                   20851              2576
            65%overvalued                                   21502              2656
            70%overvalued                                   22154              2737


* 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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