Saturday, January 13, 2018

The Closing Bell

The Closing Bell

1/13/18

Statistical Summary

   Current Economic Forecast
                       
2018 estimates (revised)

Real Growth in Gross Domestic Product                          1.5-2.5%
                        Inflation                                                                          +1.5-2%
                        Corporate Profits                                                                5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                                 23424-25806
Intermediate Term Uptrend                     12863-29069
Long Term Uptrend                                  6009-29456
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2357-3128
                                    Intermediate Term Uptrend                         1243-3057
                                    Long Term Uptrend                                     905-2963
                                                           
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 an upward bias to equity valuations.   The data flow this week was mixed: above estimates: weekly mortgage and purchase applications, November wholesale and business inventories/sales, December PPI, December import and export prices, the December budget deficit; below estimates: November consumer credit, weekly jobless claims, December retail sales, month to date retail chain store sales, December small business optimism survey, December CPI, ex food and energy; in line with estimates: none.

However, the lone primary indicator was negative: December retail sales.  The call this week is negative---but clearly just barely.  Score: in the last 118 weeks, forty were positive, fifty-seven negative and twenty-one neutral.

Given the paucity of data, I am not going to read too much into this week’s numbers.  I think they will matter only if we see a further weakening in the stats.  I will reiterate a point I made on Friday: while the PPI reading was undeniably upbeat, it nonetheless was a decline in a sustained two year uptrend.  Like this week’s data, it is only meaningful if it reverses that trend.

Overseas, the datapoints were also scarce but the pattern remained the same: strength in Europe which is likely contributing to a pick in growth here; not so much in the rest of the globe---in China the stats were mixed

In short, the trend in global growth remains upbeat.  In my mind, the issue remains the duration of this growth spurt.  And as you know, I believe that it will be short lived.  Certainly, this week’s less than stellar numbers suggests that as a possibility; though as I stated above, it is far too soon to be making that call. My bottom line is that I don’t see how the US/rest of the world can undergo a rise in its long term secular growth rate at the same time that the magnitude of the  levels of debt that have to be serviced are so high---and rising.

Having said that, I have already raised my long term secular economic growth rate assumption based on an improved regulatory environment.  Finally, remember that I am not bear on the economy. My issue isn’t whether it will keep growing; my issue is by how much.

Our (new and improved) forecast:

A pick up in the long term secular economic growth rate based on less government regulation.  As a result, I have raised our 2018 growth forecast. This increase in secular growth could be further augmented by pro-growth fiscal policies including repeal of Obamacare and enactment of (revenue neutral) tax reform and infrastructure spending.  We may be getting the former, but, unfortunately, not the revenue neutral tax reform as it will expand the national debt by another $1.5 trillion.  As a result, I fear the odds of an additional bump in the long term secular growth rate of the economy are low.

Counterpoint:

To be sure, short term growth is improving, propelled by improved psychology and a pickup in international growth.  However, I have doubts that the former will lead to any permanent increase in the long term secular growth rate.
                       
       The negatives:

(1)   a vulnerable global banking system.  Nothing new.

(2)   fiscal/regulatory policy. 

There were kerfuffles in the area of trade this week [China, NAFTA], both of which I have covered and the results of which is that it appears little will come of them.  But I do want to repeat my bottom line on this issue:  free trade is good for everyone.  It expands economic growth for both parties.  Sometime trade agreements need to be updated due to changing economic circumstances---which I hope is what is occurring now.  That is also good, assuming each party can negotiate in good faith.

The US trade deficit keeps getting bigger (medium):

The other development that bears comment is the Donald’s statement that congress ought to bring back earmarks.  While he is correct is saying that it would make the passage of legislation easier [essentially buying votes with your and my money].  And it clearly reflects the mentality of ‘deal maker’.  However, with the US debt/deficit at record highs, in my opinion, the US cannot afford this kind vote buying scheme for the sake of passage of legislation that may not be all that positive for the US electorate in the first place.  Let’s hope this was just another the Donald’s shoot first and aim later comments.

You know my bottom line, too much debt stymies economic growth even if it partly comes from a tax cut.


(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.  

There were rumblings in two of the major foreign central banks:

[a] the Bank of Japan reduced the size of its purchases of US Treasuries in a single transaction.  The response was immediate as US long bonds sold off.  However, in a subsequent transaction, the BOJ resumed its former level of purchases.  At this point, we don’t know if there were just technical reasons for the initial reduced size of purchases or the bank was testing the waters for a policy change, i.e. the start of the unwinding of Japanese QE [higher interest rates]. 

[b] in addition, there were rumors that the Chinese were reducing the size of their US Treasury holdings [supposedly as retaliation for Trump’s tough trade talk].  That also got investors worrying about higher interest rates. Subsequently, the Chinese said that they were adjusting their reserves as a result of the decline in US Treasury prices.  While that sounds less confrontational, the result is still the same---they are selling US Treasuries.

Whatever the reasons for these central bank actions, we know the Markets reactions---which is, investors are very edgy about a concerted global unwinding of QE. 

This, of course, fits with my thesis that the Markets can’t go up on QE but not go down in its absence. It also fits with the notion that the central banks have painted themselves into a corner---which is, that they can continue QE and risk pushing inflation over acceptable levels or not and fail in their unstated, unsanctioned goal of stimulating wealth.

I have no clue what the future holds.  Although we have a sign that the Markets will not react kindly to the unwinding of QE.  You know my bottom line: when QE starts to unwind, so does the mispricing and misallocation of assets.  That thesis is about to be tested.
 
                 The absurdity of the ECB QE (medium and a must read):

(4)   geopolitical risks:  The most significant development this week relates to the reaction of the Pakistanis to the Donald’s negative tweets and threats to cut foreign aid.  I covered Pakistan’s response which was basically to tell the US to stick it where the sun doesn’t shine and open negotiations with China and Iran for aid and joint projects. 

This appears to be the first instance where the ‘art of the deal’ rhetoric has seemingly backfired.  The result in itself is not a plus as Pakistan provides critical assistance in our [losing] fight in Afghanistan.  However, if it gives other parties the courage to call Trump’s bluff, that would really spell trouble for his administration.

In addition, Trump made some nicey, nice comments on North Korea and Kim Jung Un, suggesting that the recent move by the North to re-establish contact with the South may be paying off in a lessening of tensions with the US.  That is the good news.


(5)   economic difficulties around the globe.  There were few stats this week but we got was in line with recent trends. 


[a] 2017 German GDP rose at the fastest rate in six years,

[b] a Chinese official said the 2017 Chinese GDP grew faster than forecast---remember these guys lie.  As witness to that, December Chinese exports and imports declined.

The bottom line remains the same [Europe gaining strength, Japan may be improving, China is a question simply because the government lies] but the warning light is flashing indicating the potential for a more upbeat outlook.

            Bottom line:  the US economy growth rate appears to be improving as a result of a combination of the positive impact on its secular growth rate brought on by increasing deregulation, plus rising business and consumer sentiment stemming from the passage of tax reform and the better performance of the EU economy.  The issue is, will this pick in economic activity have any legs?  I remain skeptical because (1) the current recovery is already at record length and (2) the tax bill, in my opinion, will do little to stimulate growth.  There is the possibility that the current acceleration in economic activity is largely sentiment driven and that by itself could prove me wrong.  However, I believe that the more likely scenario is loss of business and consumer optimism when they realize the tax bill will do little to improve the economic overall well-being of this country.

In addition, the end of QE appears to be drawing ever closer, leaving the central banks with a Hobson’s choice: remain accommodative and risk higher inflation or tighten and risk unwinding the mispricing of global assets.  Whatever the outcome, it will only confirm what I have said repeatedly in these pages---the Fed has never in its history managed the transition from easy to normal monetary policy correctly and it won’t this time either.

The Market-Disciplined Investing
         
  Technical

The indices (DJIA 25803, S&P 2786) continued their melt up on higher volume and stronger breadth.  Long term, they remain robust viz a viz their moving averages and uptrends across all timeframes. Short term, they are above the resistance level marked by their August highs, meaning that there is no resistance between current price levels and the upper boundaries of their long term uptrends. The technical assumption has to be that stocks are going higher. 

 The VIX was again up on a solid up Market day.  For the last week, it has almost entirely divorced itself from any (inverse) correlation with stocks.  I think that means one of two things and perhaps both: (1) somebody in stock land is doing serious hedging [of their equity positions] and (2) volatility will likely be much higher going forward than it was in 2017.

The long Treasury continued its recovery from the shellacking it took following the PPI number---although it was not that impressive.  I believe that suggests that the bond boys are not convinced that the Fed will stay as accommodative as the equity investors seem to think.   That said, TLT is technically in something of a no man’s land, not providing any clear directional information. 

However, the other indicators that I follow are providing strong indications of lower rates.  On Friday, GLD was up over 1% while the dollar was down over 1%.

I remain uncomfortable with the overall technical picture.

Fundamental-A Dividend Growth Investment Strategy

The DJIA and the S&P are well above ‘Fair Value’ (as calculated by our Valuation Model).  However, ‘Fair Value’ has risen based on a new set of regulatory policies which will lead to improvement in the historically low long term secular growth rate of the economy. 

Consequently, I raised my 2018 GDP, corporate growth and Fair Value estimates.  However, I have serious doubts that the tax reform bill will do anything to further improve the long term secular economic growth rate.  That said, I have to point out that (1) at the moment, a six week improvement in the data suggests that I am wrong and (2) a number very smart analysts for whom I have great respect disagree with this position.  We will probably know who is right sometime in early 2018.

In short, I believe that Street estimates for economic and corporate profit growth based on a stimulative tax reform are too optimistic.  As a result, if stocks continue to fly on this notion, they will discount even more future growth that is either not there or so far in the future as to not be really relevant to today’s valuations.  And when investors wake up from this fairy tale that could, in turn, lead to declining valuations. 

That said, fiscal policy is a distant second where it comes to Market impact.  The 800 pound gorilla for equity valuations is central bank monetary policy based on the thesis that (1) QE did little to help the economy but led to extreme distortions in asset pricing and allocation and (2) hence, its unwinding will do little to hurt the economy but much to equities as the severe perversion of security valuations is undone. 

At this point, I couldn’t be more at odds with Market extremely positive sentiment grounded on the assumption that the Fed has the Market’s back and will pursue the unwinding of QE only to the extent that it does not disrupt the Markets.  That may be true if the Fed was the only central bank that was tightening---which, in fact, it has been up until recently.  Now the central banks of Japan and China are making noises that suggest less accommodative monetary policy is in the near future.   Plus the ECB is scheduled to begin shifting towards unwinding its own version of QE later this year. To be sure, all these guys have mewed about tightening monetary policy before and done nothing.  And that may prove to be the case this time around. 

But whether it does or not, it won’t change the fact that the global monetary authorities have created huge asset price distortions just as they did in 2000 and 2008; and given their abject failure to transition to normalize monetary policy in the past, I doubt that they will do so this time.  Unfortunately, this time around those distortions are the most extreme in history; so I expect the subsequent price adjustments will be very painful.

Bottom line: the assumptions on long term secular growth in our Economic Model have improved as a result of a new regulatory regime.  Plus, there is a ray of hope (though fading) that fiscal policy could further increase that growth assumption though its timing and magnitude are unknown.  On the other hand, (1) if Trump follows through with his trade threats, and/or (2) the deficit/debt continues to rise, I believe that it would negate any potential positive. In any case, I continue to believe that the current Street narrative is overly optimistic---which means Street models will ultimately will have to lower their consensus of Fair Value for equities. 

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.

                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 the current price strength to sell a portion of my winners and all of my losers.
               
DJIA             S&P

Current 2018 Year End Fair Value*              13860             1711
Fair Value as of 1/31/18                                  13266            1637
Close this week                                               25806            2786

* 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.