Tuesday, October 16, 2018

The Morning Call--All eyes on the 200 DMA


The Morning Call

10/16/18

The Market
         
    Technical

After remaining in plus territory for most of the day the Averages (DJIA 25250, S&P 2750) faded near the close to end in down for the day.  Traders’ eyes are now on the S&P which retreated off its 200 day moving average, restarting the clock (now support; if it remains there through the close on Wednesday, it will revert to resistance).  I previously noted that this MA has offered major support for the last two years.  Reverting to resistance would be a significant occurrence to the technicians. Volume declined and breadth was mixed.

The VIX fell 9 %, a bit unusual for a down day in stocks, but it retains its positive chart.

The long bond was unchanged.  It remained in an intermediate term downtrend, a long term trading range and below both MA’s.   Still a negative technical picture.

The dollar was down fractionally, but continues to have a positive technical standing.  Though failing to challenge its August high is a bit of a negative.  However, I continue to believe that UUP will move higher as long as the dollar funding problem persists. 

GLD was back in positive territory, finishing above the upper boundary of its short term downtrend for a third day, resetting to a trading range.  This is the first positive technical development for gold in a long, long time.  Follow through.

 Bottom line: the key technical issue at the moment is how the S&P trades around its 200 DMA.  A reversion to resistance would likely have a big negative impact on the technical community’s outlook for the Market.  To be clear, we are only in a challenge phase.  So it is too soon to toll the funeral bells.  But today’s and tomorrow’ pin action are more important than usual.

Taking a step back, it is important to view (Wednesday and Thursday’s pin action) with some perspective---that is, that (the Averages) are barely off their all-time highs.  So it is no time to get beared up.  Even though I have thought that stocks were overvalued for over the last two years and that a selloff was due, it doesn’t mean that mean reversion has started.  On the other hand, every journey starts with a single step.

          GLD’s performance over the last three trading days may be giving a hint as to how the challenge of the S&P’s 200 DMA will be resolved (negatively).

            Monday in the charts.

    Fundamental

       Headlines

            Yesterday’s economic data was mixed: August business inventories/sale were in line, September retail were awful, the October NY Fed manufacturing index was above forecast.
           
            The big headline (at least for me) was the confirmation that the US budget deficit continues to grow.  See below.

            Bottom line: I won’t bother you with another ‘irresponsible fiscal policy’ harangue; but I will repeat my thesis: with the national debt at its level  viz a viz GDP, deficit spending is a drag on economic growth because servicing it usurps monies that would other go to investment/consumption.  And our ruling class is doing at exactly time in the economic cycle that the government should be running a surplus.

    News on Stocks in Our Portfolios
 
W.W. Grainger (NYSE:GWW): Q3 Non-GAAP EPS of $4.19 beats by $0.24; GAAP EPS of $1.82 misses by $2.10.
Revenue of $2.83B (+7.2% Y/Y) misses by $10M.

Johnson & Johnson (NYSE:JNJ): Q3 Non-GAAP EPS of $2.05 beats by $0.02; GAAP EPS of $1.44 misses by $0.44.
Revenue of $20.35B (+3.6% Y/Y) beats by $300M.

BlackRock (NYSE:BLK): Q3 Non-GAAP EPS of $7.52 beats by $0.65; GAAP EPS of $7.54 beats by $0.71.
Revenue of $3.58B (+2.0% Y/Y) misses by $60M.

Economics

   This Week’s Data

      US

            August business inventories rose 0.5%, in line; sales were also up 0.5%.

The US FY2018 budget was $779 billion up 17% from FY2017.

     International

            October German investor sentiment came in at -24.7 versus estimates of -12.0.

            The Italian government agreed on budget with a deficit that is above EU guidelines.

    Other

            Money for nothing and ……….


What I am reading today

           

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Monday, October 15, 2018

Monday Morning Chartology


The Morning Call

10/15/18

The Market
         
    Technical

            Last week, the S&P negated its very short term uptrend and reverted its 100 DMA from support to resistance.  Most important, it is now in a challenge of its 200 DMA.  It broke below this support level on Thursday---a support level, by the way, that has been challenged multiple times over the last two years and held.  On Friday, the S&P closed right on that MA, which in my time and distance discipline, stops but does not reset the clock.  In other words, if it closes below the 200 DMA today, it will restart the clock (which means Monday will be the second day of the break); if it closes above the MA, the break will be voided.  So on a short term basis, the S&P is at a critical technical level.  Today’s pin action will tell us a lot.  Incidentally, the Dow closed above its 200 DMA, negating Thursday’s break which is a mildly positive indicator for what the S&P might do today.



            The long bond had one good day (Thursday) last week in which its role as a safety trade seemed to kick in.  However, it was unable to rise above the lower boundary of its former intermediate term trading range, lending strength to the new downtrend.  It is also it remains below both moving averages, in a short term downtrend and in a newly reset long term trading range.  In short, it looks like more downside in prices.



            The dollar sold off last week though it was up on Friday.  It remains strong technically; but I was a bit mystified by its decline on Wednesday and Thursday since it is usually associated with a safety trade.



            GLD exploded upward on Thursday on huge volume, challenging a six month losing streak.  If it manages to stay above the upper boundary of its short term downtrend on the close today, it will reset to a trading range.  While it might be relinquishing the title of ‘ugliest chart on the block’, it is still no time to get jiggy.



            The VIX soared last week closing above both moving averages and resetting its short term trend from a trading range to an uptrend.  Not a good sign for stocks.



    Fundamental

       Headlines

      
           

    News on Stocks in Our Portfolios
 
           

Economics

   This Week’s Data

      US

            September retail sales rose 0.1% versus expectations of up 0.6%; ex autos, they were -0.1% versus estimates of +0.4%

            The October NY Fed manufacturing index came in at 21.1 versus consensus of 18.8.

     International

    Other

            Update on the used car market.

What I am reading today

            Your work is the only thing that matters.
           
            Monday morning humor.

                        The tightening alliance between Russia and India.

                Problems in the Chinese housing market.



  
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Saturday, October 13, 2018

The Closing Bell


The Closing Bell

10/13/18


Statistical Summary

   Current Economic Forecast
                       
2018 estimates (revised)

Real Growth in Gross Domestic Product                          1.5-2.5%
                        Inflation                                                                          +1.5-2%
                        Corporate Profits                                                                10-15%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      21691-26646
Intermediate Term Uptrend                     13678-29883
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2665-3436
                                    Intermediate Term Uptrend                         1315-3130                                                          Long Term Uptrend                                     905-3065
                                                           
2018 Year End Fair Value                                       1700-1720         


Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          59%
            High Yield Portfolio                                     55%
            Aggressive Growth Portfolio                        55%

Economics/Politics
           
The Trump economy is providing a slight upward bias to equity valuations.   The data flow this week was mixed: above estimates: month to date retail chain store sales, August wholesale inventories/sales, September CPI; below estimates: weekly mortgage and purchase applications, weekly jobless claims, preliminary October consumer sentiment; in line with estimates: the September small business optimism index, September PPI, September import/export prices.

No primary indicators this week.  Since the dataflow this week was not only paltry but also mixed, I am giving a weak neutral rating.  Score: in the last 157 weeks, fifty-two were positive, seventy-one negative and thirty-four neutral.

Nonetheless, several comments: 

(1)   the PPI, CPI and export prices stats showed inflation still well under control which gives the Fed the excuse, if it chooses to use it, to ease up on its current tightening policy.  But I want to offer my opinion on a couple of things.  I keep hearing from the media that the Fed is tightening money because it fears inflation.  There isn’t any inflation. Look at the aforementioned numbers.  The Fed is tightening money because it is attempting to unwind its ginormous balance sheet which has created multiple distortions in the economy, not the least of which is the mispricing and misallocation of assets.  I also hear that long rates are rising because the Fed is raising the Fed Funds rate.  While that may play a partial role, long rates are rising because liquidity problems in the global financial system [dollar funding problems],

(2)   the IMF cut its 2018 global and US economic growth forecasts, supporting my outlook for a re-slowing of growth following the tax induced pop in the second quarter numbers,

(3)   third quarter earnings season started this week and that should give us another take on the strength of the economy.

Our forecast:

A pick up in what is now a below average long term secular economic growth rate based on less government regulation with some minor help from the recent agreements with Mexico/Canada/South Korea. There is the potential that Trump’s trade negotiations with Japan, the EU and China could also lead to a further improvement in our long term secular growth rate.  However, much more needs to be done for this factor to be a significant positive.

The tax cut and spending bills, as they are now constituted, are negative for long term growth (you know my thesis: at the current high level of national debt, the cost of servicing the debt more than offsets any stimulative benefit).

On a cyclical basis, while the second quarter numbers were definitely better than the first, there is insufficient evidence at this moment to indicate a strong follow through. 

So my current assumption remains intact---an economy growing slowly but not accelerating.  

       The negatives:

(1)   a vulnerable global banking [financial] system.  

I re-introduced this subject a couple of weeks ago, altering it slightly to incorporate the entire financial system, specifically the shadow banking system [nonbank loans from hedge funds, finance companies, etc.].  The reason being [a] the tremendous growth in this segment of the financial market [b] the weak credit standards currently demanded by the lending institutions, i.e. a lot of nonrecourse and covenant lite loans, and [c] the use of derivatives by the lenders to hedge their bets.  Recall that this was one of the main problems in the 2008/2009 crisis.  I am not suggesting that conditions can deteriorate as significantly as they did back then.  But they don’t have to in order to result in liquidity/solvency problems.


(2)   fiscal/regulatory policy. 

The principal headline this week was the announcement that Trump and Chinese Premier Xi would meet during the upcoming G20 meeting.  Even though I believe that the Donald is following the right strategy in confronting China regarding its theft of intellectual property, I don’t believe that anything material is going to happen before the November elections.  Indeed, I suspect that China has evaluated the NAFTA 2.0 deal, seen that changes from the original deal were minor and may, therefore, offer some inconsequential fig leaf that Trump would grasp in order to declare victory.  

If so, it would add to my disappointment that the NAFTA 2.0 deal wasn’t a better one for the US.  To be clear, it was a net positive; but it was not in the spirit of what I thought was Trump’s goal to re-set the post WWII political/trade regime. 

That said, like NAFTA 2.0, even a marginally better trade deal would remove the negative that a slowdown in trade based just on the uncertainty of the situation would have on the US economy.  So on a cyclical basis, it would be a plus.  However, long term, slightly better trade deals are not going to have that large an impact on the secular growth of the economy and that is potentially a factor that I have hoped would help the US economy regain its former secular growth rate.

Unfortunately, the real turd in the fiscal policy punchbowl is the growing budget deficit/national debt at the same time the economy is doing well.  That is exactly opposite of how fiscal policy is supposed to work, i.e. deficits during recessions, surpluses during booms.  And I don’t think this situation is going to get any better---plans abound for additional tax cuts and more spending.

You know my bottom line: once the national debt reaches a certain size in relation to GDP [and the US has already attained that dubious honor] the cost of servicing that debt offsets any benefits to growth that might come from tax cuts/infrastructure spending.

(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  asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.  

The most important question on this point is, does Powell really mean that the Fed will continue to tighten money, irrespective of its impact on the Market?  As you know, my opinion since the inception of QEII was that it was a major mistake for the [Bernanke/Yellen] Fed to add the stabilization of financial markets as a third objective to its congressionally mandated goals of containing inflation and unemployment.  It destroyed price [risk] discovery and led to the gross mispricing and misallocation of assets.  If that regime is over then sooner or later price discovery will return. 
                                     
The Fed is undergoing a change in attitude.


Another consequence of a tightening monetary policy is the pressure is puts on weak foreign issuers of dollar denominated debt.  We are already seeing funding problems not only in emerging markets like Argentina, Turkey, Pakistan, India and the Philippines but also larger economies like China and the EU.

You know my bottom line: the unwinding of QE will have little effect on the US economy but will reverse the gross mispricing and misallocation of assets.

When the next recession hits.

(4)   geopolitical risks:  the denuclearization of North Korea seems to be moving forward [‘seems’ being the operative word] though Syria remains a flash point, as well as the current instability related to Brexit and Italy’s fight with the ECB.  All risks; none on the front burner.

Though Italy may soon be.


(5)   economic difficulties around the globe.  The stats this week were negative:

[a] September EU manufacturing PMI was slightly below forecasts,

[b]  the September Chinese trade surplus with the US hit a record $34.1 billion.

            Bottom line:  on a secular basis, the US is growing at an historically below average secular rate although I assume decreased regulation and the likely successful completion of the NAFTA 2.0 agreement will improve that rate somewhat.  Certainly, removing the uncertainty of no NAFTA treaty should help return economic conditions to what they were before.  The same is equally true if Trump is successful in revising the trade agreements with the EU, Japan and China.  ‘If’ being the operative word, especially as it applies to China where it looks like the current standoff will prove protracted.

At the same time, these long term positives are being offset by a totally irresponsible fiscal policy.  The original tax cut, increased deficit spending, a potentially big infrastructure bill and funding the bureaucracy of a new arm of the military (space force) will push the deficit/debt higher, negatively impacting economic growth, in my opinion.  Until evidence proves otherwise, my thesis remains that cost of servicing the current level of the national debt and budget deficit is simply too high to allow any meaningful pick up in long term secular economic growth.

Cyclically, growth in the second quarter sped up, helped along by the tax cuts.  At the moment, the Market seems to be expecting that acceleration to persist.  I take issue with that assumption, based not only on the falloff in global activity but also the lack of consistency in our own data and the never ending expansion of debt.

The Market-Disciplined Investing
         
  Technical

We finally got the oversold rally on Friday with the Averages (DJIA 25339, S&P 2767) closing nicely higher.  However, in the preceding decline, the S&P voided its very short term uptrend, reverted its 100 DMA from support to resistance and is on the cusp of doing the same with its 200 DMA.  It did manage to close right on the boundary which simply extends the clock by a day; in other words, it now has to remain below this MA until Wednesday to confirm the break.  Of course, any close above it would negate the break.

The Dow did a bit better, finishing back above its 200 DMA voiding that break but remained below its 100 DMA (now support, if it remains there through the close on Monday, it will revert to resistance).  The latter is a mildly hopeful sign that the S&P could follow suit.

Volume declined and breadth recovered though only slightly.

The VIX fell 14 ½ %, but remained above its 100 DMA (now support) and its 200 DMA (now support) and the upper boundary of its short term trading range, resetting to a short term uptrend.  A negative for stocks. 

The long bond resumed its decline after a huge spike on Thursday.  Despite the pop, TLT remained in an intermediate term downtrend (it failed to even recover the lower boundary of its former intermediate term trading range), a long term trading range and below both MA’s.   Still a negative technical picture.

The dollar was up fractionally, retaining its positive technical standing.  Though failing to challenge its August high is a bit of a negative.  However, I continue to believe that UUP will move higher as long as the dollar funding problem persists. 

GLD sold off ½ % following Thursday’s major jump on massive volume.  However, it remained above the upper boundary of its short term downtrend (if it remains there through the close on Monday, it will reset to a trading range).  This is the first positive technical development for gold in a long, long time.  Follow through.

 Bottom line: Friday’s rally off an extremely oversold condition was to be expected.  For it to be anything more, the S&P needs to end above its 200 DMA and the Dow to hold above its 200 DMA on Monday. (Remember, those 200 DMA’s have represented major support on multiple occasions for almost two years.)  As always, follow through from critical technical levels is most important.  Patience.

To repeat, my Friday observation:  Taking a step back, it is important to view (Wednesday and Thursday’s pin action) with some perspective---that is, that (the Averages) are barely off their all-time highs.  So it is no time to get beared up.  Even though I have thought that stocks were overvalued for over the last two years and that a selloff was due, it doesn’t mean that mean reversion has started.  On the other hand, every journey starts with a single step.

          Bonds, the dollar and gold continue to trade at odds with each other, though I think that the ‘safety trade’ element got mixed into the fundamental considerations on Wednesday and Thursday.
           
                Friday in the charts.

Fundamental-A Dividend Growth Investment Strategy

The DJIA and the S&P are well above ‘Fair Value’ (as calculated by our Valuation Model), the improved regulatory environment notwithstanding.  At the moment, the important factors bearing on Fair Value (corporate profitability and the rate at which it is discounted) are:

(1)   the extent to which the economy is growing.  Clearly, the second quarter GDP number propelled by the tax cuts was a sign of improved growth.  Nevertheless, that is a single stat and in no way implies a trend.  Indeed, [a] most Street estimates for third quarter GDP growth are lower than that of Q2, [b] the Fed’s forecast for longer term growth shows a gradual decline back toward what has been a below average secular growth rate and [c] the forward {sales and earnings} guidance from many companies has begun to decline {autos, construction, airlines, packaging}.

Unless those tax cuts alter investing and consumption behavior on a more permanent basis, Q2 growth will likely prove to be the peak growth rate of this economic cycle.  Furthermore, the effect that those tax cuts are, at least presently, having on the deficit/debt are just as meaningful, in my opinion, as any growth implications, to wit, financing the deficit and servicing of debt will constrain growth.

My conclusion remains that while the economy has experienced a pop in its cyclical growth resulting from the tax cuts, it simply can’t and won’t sustain that growth rate on a secular basis and will gradually revert back to the pre-tax cut, below average (less than ~2%) rate.  To be clear, I am not saying that the economy is going into a recession.  And while there clearly is some probability of a pickup in the long term secular growth rate of the economy [deregulation, trade], I am not going to change a forecast, beyond what I have already done, based on the dataflow to date or the promise of some grand reorientation of trade.

Also, lest we forget, the growth rate in rest of the global economy has slowed and will not be helped by the decelerating effects of the dollar funding problems in the emerging market.  That can’t be good for our own prospects.  It is certainly possible, even probable, that the US can continue to grow as the rest of the world slows.  But it is not likely that its second quarter growth rate will be maintained.  

My thesis remains that the financing burden now posed by the massive [and growing] US deficit and debt has and will continue to constrain economic as well as profitability growth.

In short, the economy is not a negative but it not a positive at current valuation levels.

(2)   the success of current trade negotiations.  If Trump is able to create a fairer political/trade regime, it would almost certainly be a plus for secular earnings growth.  Clearly, the US/Mexico/Canada and South Korean agreements are a step in that direction.  But there is general agreement [except within the Administration] that these revised treaties will barely move the needle on the secular growth rate of the economy; though certainly there be a cyclical effect from the removal of uncertainty.

However, the US remains at loggerheads with China.  Plus Trump is insisting on a changes in the terms of our trade agreements with Japan and Europe.  So there is much to be done before altering any assumptions about an improvement in economic growth.

Nonetheless, my bottom line is that I, perhaps foolishly, remain optimistic that the Donald’s current negotiating strategy will pay off; hopefully with better results than NAFTA 2.0.  However, the risks and rewards associated with failure and success are very high.  Either outcome would almost surely have an impact on corporate earnings and, probably, on stock prices.

(3)   the rate at which the global central banks unwind QE.  At present, it is happening.  The Fed continues to raise rates, its forward guidance is to expect more hikes and a continuation of the run off of its balance sheet. Perhaps most telling is the comments from various FOMC members that the Fed is no longer reacting with any sensitivity to the Markets---assuming they really mean it.  I have opined that this would drive the after effects of QE, i.e. the return to price discovery and the correction of the mispricing and misallocation of assets.  And, the Market aside, we are starting to see those after effects in the dollar funding problems in foreign economies.

I remain convinced that [a] QE has done and will continue to do harm to the global economy in terms of the mispricing and misallocation of assets, [b] sooner or later that mispricing/misallocation will be reversed and [c] given the fact that the Markets were the prime beneficiaries of QE, they will be the ones that take the pain of its demise. 

(4)   finally, notwithstanding two rough trading days this week, valuations remain at record highs [at least as calculated by my Valuation Model] based on the current generally accepted economic/corporate profit scenario which includes an acceleration of economic growth [which I consider wishful thinking].  Even if I am wrong, there is no room in those valuations for an adverse development which we will inevitably get.

However, I would reemphasize a point that I made early in the week:  we have witnessed air pockets in stock prices many times in this current bull market that soon recovered because [a] the economy was slowly albeit sluggishly improving and [b] the Fed had its foot on the accelerator. 

Now [a] interest rates are up, [b] the Fed continues to shrink money supply and that is causing dollar funding indigestion not only in the emerging market but also seems to spreading to the developed markets; as important, Powell has made clear that he expects to continue to tighten whatever happens to the Markets---a massive change in attitude from the Bernanke/Yellen regimes, [c] corporations have record levels of debt, especially in the lower rated credit segment and [d] are starting to lower profit expectations, [e] finally…..the bugaboo from the last financial crisis, i.e. derivatives, has reappeared with all its associated counterparty risks.

Bottom line: a new regulatory regime plus an improvement in our trade policies should have a positive impact on secular growth and, hence, equity valuations.  On the other hand, I believe that fiscal policy will have an opposite effect on economic growth.  Making matters worse, monetary policy, sooner or later, will have to correct the mispricing and misallocation of assets---and that will be a negative for the Market.

Our Valuation Model assumptions may be changing depending on the aforementioned economic tradeoffs impacting our Economic Model.  However, even if tax reform proves to be a positive, the math in our Valuation Model still shows that equities are way overpriced.  That math is simple: the P/E now being paid for the historical long term secular growth rate of earnings is far above the norm.

                As a long term investor, with equity valuations at historical highs, I would want to own some cash in my Portfolio; and if I didn’t have any, I would use any price strength to sell a portion of my winners and all of my losers.

                As a reminder, my Portfolio’s cash position didn’t reach its current level as a result of the Valuation Models estimate of Fair Value for the Averages.  Rather I apply it to each stock in my Portfolio and when a stock reaches its Sell Half Range (overvalued), I reduce the size of that holding.  That forces me to recognize a portion of the profit of a successful investment and, just as important, build a reserve to buy stocks cheaply when the inevitable decline occurs.

DJIA             S&P

Current 2018 Year End Fair Value*              13860             1711
Fair Value as of 10/31/18                                13796            1702
Close this week                                               25339            2767

* 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 50 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.