Saturday, January 20, 2018

The Closing Bell

The Closing Bell

1/20/18

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                                 23465-25909
Intermediate Term Uptrend                     12865-29071
Long Term Uptrend                                  6185-29632
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2371-3142
                                    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 slightly negative: above estimates: weekly mortgage and purchase applications, weekly jobless claims, December industrial production; below estimates: December housing starts, the January housing market index, January consumer sentiment, month to date retail chain store sales, the Philly Fed manufacturing index; in line with estimates: the January/revised December NY Fed manufacturing index.

           
The primary indicators were mixed: December industrial production (+), December housing starts (-).  The call this week is neutral.  Score: in the last 119 weeks, forty were positive, fifty-seven negative and twenty-two neutral.

This is the second week in a row of less than stellar stats.  Of course, two weeks don’t make a trend.  Plus I think that the increase in sentiment brought on by corporate reactions (increased cap spending and raising wages) following the tax bill could start to show up in the economic data at some point. 

Indeed, as I noted in Thursday’s Morning Call, I believe that the positive changes in corporate spending plans could potentially have a positive impact on economic growth---assuming that they are an indication that other corporate entities will follow suit.  So at this moment, I am not concerned by this week’s data.   In fact, if cap higher spending and hiring become the trend, I will be raising my 2018 economic growth rate forecast for a second time.

Overseas, there wasn’t a lot of data but what we got was largely upbeat---low inflation in Europe and growth in China.  All of this fits the developing theme of strength in the EU and improvement in China (if they are telling the truth).

In short, the trend in global growth remains positive.  And it could be given a further boost by developments in corporate spending patterns in the US.  As I noted, it is too soon to make that call; but I am hopeful.  I continue to believe that the tax plan is flawed (it is not simpler, it is not fairer and whether or not it is pro growth is now the issue); but it appears, at least initially, that corporations don’t see it as flawed as I do.

In my mind, the issue still remains the magnitude and duration of this growth spurt.  The key factors determining the answer to that question are (1) the scale of the change in corporate spending plans, (2) how much of a lid the current debt servicing requirements will place on the economy’s growth potential, (3)  whether or not Trump makes good on his trade threats and (4) the Fed’s response.

As you know, I have already raised my long term secular economic growth rate assumption based on an improved regulatory environment.  With any meaningful follow through by the business community upping cap spending and hiring plans, I will most likely do so for a second time.  My issue isn’t whether the economy 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; and much to my surprise, we seem to be getting a much more pro-growth response to the tax bill from corporate America than I had expected.  The latter is not yet in the forecast because it is simply too soon to project a change of trend.  And even when, as and if it is, the question remains the degree to which the tax bill’s lack of revenue neutrality will act as a governor on potential growth.

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

(1)   a vulnerable global banking system.   

Friday, it was reported that the Fed is working to relax a key part of the post-crisis demands for drastically increased capital levels at the biggest banks; a move that could free up billions of dollars for some Wall Street giants.

Yeh, that is just what we need.  Turn these guys loose to continue their good work manipulating markets, developing questionable securities to pawn to the public and generally lever up their balance sheets with risky assets.

Not good.

Jeffery Snider on our ‘fortress banks’ and the Fed (medium):

(2)   fiscal/regulatory policy. 

Several factors were at play this week.

[a] the continuing positive reaction by US businesses to the tax bill.  I covered this above and to a greater extent in Thursday’s Morning Call; so I am not going to belabor the point.   The bottom line is that I am surprised {and wrong} about corporate moves to date raising cap spending and increasing hiring.  If that continues, I will raise the long term secular economic growth rate assumption---‘if’ being the operative word.  The question is, by how much?

Perhaps the answer from the Atlanta Fed (medium):

[b] part of the answer is how aggressively the Donald pursues his trade threats.  I agree that some adjustments need to be made in NAFTA and our trade relations with China.  My concern is that Trump pushes too hard and the result is diminished trade---which would not be good for growth,


[c] another part of the answer is how our ruling class handles the current budget/immigration bills which now appear joined at the hip---a circumstance that could only occur when politicians get involved.  Unfortunately, there doesn’t appear to be any good outcome to this problem: {i} a government shutdown (which we now know to be the case) would not be helpful to the economy and/or {ii} a budget that jacks up spending (deficit/debt) will only exacerbate the current debt service problem.  The best alternative would be voting the continuing resolution into infinity; but why would this group of yahoos do anything fiscally responsible?

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.  

The FOMC released its latest Beige Book.  It read pretty much as expected: growth continues, the labor market is tightening. zzzzzzzzzz

This week’s real issue is, what does the Fed do if the surprising [to me] recent increase in corporate investment and hiring turns out to be the real McCoy and we start seeing a meaningful pickup in economic activity and inflation.  Again, I covered its potential choices in this Thursday’s Morning Call as well as every other missive I have ever written. 

The other consideration which few are talking about is the shellacking that the dollar is taking.  If this continues, at some point, the Fed is going to have to raise interest rates to stabilize the dollar irrespective of how fast the economy is growing or how tame the rate of inflation.

The bottom line is that if growth picks up or the dollar continues to fall, the Fed has no good alternatives.  It has left itself in the same place as every other Fed in the history of Fed; that is, it has waited too long to begin normalizing monetary policy and now it must either hold to its dovish ways and risk a big spike in inflation or begin to tighten policy more aggressively and risk cutting off a potential increase in the long term secular growth rate in the economy just as it is starting. 

The Fed has f**ked the pooch again. You know my bottom line: when QE starts to unwind, so does the mispricing and misallocation of assets. 
               

(4)   geopolitical risks:  Not a lot occurred this week on this subject.  Perhaps the most noteworthy was the continuing love fest between the two Koreas.  I don’t mean to make light of it; because it is positive.

(5)   economic difficulties around the globe.  Which there seems to be less and less of.  I know that I have said this before; but much more of this, I am going to remove it as a risk. 


[a] the December UK and EU CPI’s were in line, December UK retail sales declined,

[b] December Chinese GDP was reported +6.8% versus expectations of +6.7%, industrial production +6.2% versus 6.1%, retail sales +9.4% versus 10.2% and fixed asset investment +7.2% versus 7.1%.
                   https://www.zerohedge.com/news/2018-01-19/blatant-dishonesty-boom (must read)

The bottom line remains the same: Europe gaining strength, Japan may be improving as is China, if we assume the data that it is reporting is reasonably accurate.

            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, the better performance of the EU economy, rising business and consumer sentiment stemming from the passage of tax reform and could be helped further if the initial positive actions by the business community turns into a trend.  

And that is the big issue before us: will the recent corporate actions lead to a pickup in economic activity, and if so, does it have any legs?  To be fair, I am less skeptical about the impact of the tax bill than I have been and, hence, more hopeful (although I stand by the thesis that this bill is not fairer or simpler; what is going to be tested is whether it is more pro-growth than I thought). 

However, we only have three weeks of data; so we need more time to determine just how wide spread the increase in capital spending and hiring becomes.  In addition, (1) the results of the ongoing trade negotiations with NAFTA and China, and (2) the magnitude of additional debt that will inevitably get loaded into the current budget negotiations in order to secure passage are considerations to be factored into any economic growth projections.  At the moment, I need more information. 

All that said, while less regulation, more capital investment and improving wages (assuming it occurs) will have a positive impact on the long term secular growth rate of the economy, nearer term the elephant in the bathtub is Fed policy if growth and inflation pick up and/or the dollar keeps getting pummeled.  On this part of my forecast, I haven’t changed.  The central banks have deliberately and with malice of forethought created a Hobson’s choice for themselves: 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 26071, S&P 2810) were quiet most of the day, watching our ruling class attempt to agree on a continuing resolution; then, they closed to the upside as the chances of some agreement improved (ooops).  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 decline 8% on Friday, trading in its normal inverse relationship with stock prices for the first time in a week.  I have no opinion on what this means. But follow through will tell us more.
 
The long Treasury fell again, this time falling below its 200 day moving average (now support); if it remains there through the close next Wednesday, it will revert to resistance.  While TLT remains in a technical no man’s land, its recent pin action seems to be pointing to a resolution on the downside (higher rates, stronger economy). 

The dollar managed a four cent rally which did little to alter its downhill slide.  I see nothing positive about a falling dollar and can think of a lot of negatives.  For one, it suggests loss of confidence in the US economy which is clearly contradictory to euphoria being expressed by US investors.  If it continues, at some point, the Fed will have to step in to defend the dollar and perhaps aggressively (as in raising interest rates), depending on the magnitude and rate of the dollar’s decline.  That could play merry hell with the ‘measured’ unwinding of QE.

GLD moved higher, though it is still challenging the lower boundary of its very short term uptrend.  Generally, GLD trades inversely to the dollar but in line with the long bond.  So Friday’s pin action was open to multiple interpretations.

Bottom line: investors appeared cautious Friday awaiting the results of the latest congressional circle jerk. Whatever the outcome (which we now know), I don’t think it will be enough to throw the technicals out of whack.  Meaning that current weight of technical evidence is that stocks appear likely to go higher.  But the further the current ‘melt up’ goes, the more tenuous that assumption becomes.  

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.  Further, there is the chance that the economic growth rate could be even higher if the recent trend continues in enhanced corporate spending stemming from the tax bill.

Consequently, I raised my 2018 GDP, corporate profit growth and Fair Value estimates.  And while I have expressed serious doubts that the tax reform bill would do anything to further improve the long term secular economic growth rate, the aforementioned pattern of increasing investment and hiring seems to be proving me wrong.  It is still too soon to alter my forecast; but we should have enough data/experience in the first quarter to make that call. 

As I have already said, I don’t believe that a more rapidly improving economy (1) justifies current valuations and (2) may even exacerbate the real problem facing the Markets---which is Fed policy/QE and the fact that, to the extent it should have ever been used in the first place, the Fed has waited far too long to begin unwinding it.  We are likely at or near the point where the Fed will be forced to make decision with no good alternatives---either stay dovish and risk an escalation in inflation or put the hammer down and risk truncating the current pickup in economic activity. 

I want to reiterate a point related to the latter point; that is, I don’t believe that a tighter Fed will cause a recession because QE did very little to help the economy.  But it will put a governor on the rate of economic progress.  However, it will have a significant negative impact on equity valuations because that was where QE had its positive effect.  I don’t know how the Market can go up on the presence of an easy Fed and also go up in its absence; especially when it has led to the gross mispricing and misallocation of assets.

At this point, I couldn’t be more at odds with Market’s 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 in the absence of a pickup in growth or a continuing decline in the dollar or 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 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 or, at least, partially 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                                               26071            2810

* 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.