Saturday, February 10, 2018

The Closing Bell

The Closing Bell


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                                 23729-26205
Intermediate Term Uptrend                     12986-29192
Long Term Uptrend                                  6222-29669
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2390-3161
                                    Intermediate Term Uptrend                         1248-3062
                                    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%

The Trump economy is providing an upward bias to equity valuations.   The data flow this week was meager but slightly positive: above estimates: weekly jobless claims, January retail chain store sales, December wholesale inventories and sales, the January ISM nonmanufacturing index; below estimates: month to date retail chain store sales, the December trade balance; in line with estimates: weekly mortgage/purchase applications, December/November consumer credit, the January Markit services PMI.

There were no primary indicators reported.  The call this week is positive, but a weak positive.  Score: in the last 122 weeks, forty-two were positive, fifty-seven negative and twenty-three neutral.

This dearth of stats means that there is nothing to add to the narrative of the prior weeks; which is, that the trend in the last six weeks has been very much akin to 2017 as a whole---below average growth.  That, in turn, raises two questions: (1) how much of the November/early December surge was a function of recovery activity from the hurricanes and wild fires? and (2) while there has been a definite improvement in psychology resulting from the increase in wage and cap spending by corporations, it is not yet showing up in the numbers.  So when is that going to happen?

As to the latter, there has been a marked slowdown in the last two weeks in the pace of announcements from companies increasing wages and cap ex.  That is not to say that the trend is over; but if what we got is all that we are going to get, then any growth impulse from the prior activity will probably be less than many hoped for.

Overseas, the data remains upbeat---growth and improving business confidence around the globe. All of this fits the developing theme of strength in the EU and improvement among the other major economies.  In short, the trend in global growth remains positive. 

The big item this week in economic news was the congressional passage of legislation that will up government spending (deficit) and eliminate the debt ceiling.  I have beat this rented mule already in my Morning Calls and will do more of it below.  The bottom line is that this action risks introducing an inflationary impulse that may force the Fed to tighten much quicker and much further than it wants.

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 tax reform and infrastructure spending.  While the tax bill was not perfect, much to my surprise, we initially received a much more pro-growth response to it from corporate America than I had expected.  The latter is not yet in the forecast because (1) it is too soon to project a change of trend and (2) what trend there was seems to have fizzled.  And even when, as and if it does, the question remains the degree to which the tax bill’s lack of revenue neutrality will act as a governor on potential growth.

       The negatives:

(1)   a vulnerable global banking system.  The Fed slammed Wells Fargo this week for its continuing egregious treatment of its customers.  I linked to the article on Monday, so I won’t repeat any commentary.  I just point out that the banksters haven’t changed their policies of growing profitability by hook or by crook---emphasis on the latter----and probably won’t until somebody goes to jail.

(2)   fiscal/regulatory policy. 

In the center ring this week was the multifaceted deliberations on the continuing resolution, the budget, the debt ceiling and immigration.  All wrapped up in a partisan stew of political ineptness and irresponsibility.

And true to form, our ruling class took the easy way out by raising spending and removing the debt ceiling.  Combined with the loss of revenues from the tax cut, they have now added $2 trillion to the federal deficit/debt.  In a recession, that might not be so bad.  But with the economy seemingly firing on all cylinders, the government should be reducing debt.

I have harped too many times on the effect too much debt has on economic growth; so I won’t be repetitious.  However, I will add that the risk is rising that all this new deficit spending will trigger inflationary forces and keep pushing the dollar lower.

You know my bottom line, too much debt stymies economic growth even if it partly comes from a tax cut.  And a rapidly expanding deficit and a tumbling dollar are not just bad for the country, they may push the Fed to be more aggressive in its tightening policy.  Not that I would object; but the Market would.

(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 crown was passed to Powell this week; so there is a new sheriff in town.  Whether he is as big a pussy [no pun intended] as the former chief is yet to be determined. 

That said, I linked to an article this week detailing the unwinding of QE thus far and it appears that the Fed has been more aggressive in rolling off its debt than outlined in its schedule.  There could be technical reasons for this to have occurred; but it clearly needs watching. 

This article suggests answer: the velocity of money has started to increase (medium and a must read):

In addition, the Bank of England adopted a more hawkish tone to its narrative.  While it has done nothing to date, it has indicated that a reversal in QE [rates going up higher and faster than originally projected] is in the offing.

If this trend toward unwinding QE [if indeed it is a trend] continues then we should be getting a preview to the answer to the question, if stocks went up due to QE, will they go down in its absence?  [see the S&P chart last week]

Of course, the aforementioned would be a problem under benign economic conditions.  Unfortunately, our ruling class has enacted highly stimulative spending and tax measures at a time of near full employment---which historically has been a recipe for inflation.  If it materializes, that will likely force the Fed’s hand in unwinding QE; that is, Yellen et al had dreamed of raising rates and running off its balance sheet at a slow enough pace to hopefully not disturb the Markets [‘dreamed’ being the operative word].  If that option is being removed, then it seems reasonable to expect a much more aggressive increase in rates and unwind of the $4 trillion in assets that it currently owns. 

The bottom line is that if growth/inflation picks up and/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. 

You know my bottom line: when QE starts to unwind, so does the mispricing and misallocation of assets. 

(4)   geopolitical risks:  Unicorns in South Korea.

(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 January German factory orders and the construction PMI were better than anticipated,

[b] the January Chinese trade surplus narrowed substantially {if you believe it; remember the Chinese have a vested interest in not getting into a trade war with the US over the Chinese trade surplus}.

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 faltering once again despite the positive impact on its secular growth rate brought on by increasing deregulation, the better performance of the EU economy and rising business and consumer sentiment.

However, the big issue right now is how will the tax cut and increased deficit spending impact economic growth and inflation.  And that is not factoring in a big infrastructure bill and/or the potential fallout from a more aggressive trade policy.  As you know, I have an opinion (bigger deficit/debt=slower growth; higher deficit spending=inflation) but given the unexpected positive corporate actions following the tax cut, I am hesitant to push the point too hard.

It is important to note that the real negative here is not the impact that tax cuts and increasing spending have on economic growth; it is how they might affect inflation and as a result Fed policy.  The central banks have 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

The indices (DJIA 24190, S&P 2619) managed a rally on Friday.  The S&P bounced off its 200 day moving average and both closed above their 100 day moving averages and the lower boundaries of their short term uptrends.  However, both are also in very short term downtrends.  To get jiggy about the very short term, the indices have to negate that downtrend.  Volume rose and breadth improved. It is too soon to alter the technical assumption that stocks are going higher. 

The VIX fell 13%, but remained at elevated levels---continuing to exert a negative impact on the Market.

The long Treasury declined ½ %, finishing within a point of the lower boundary of its long term uptrend.  If that level is successfully challenged, it will break a 16 year plus uptrend and point clearly at the bond markets concern about rising interest rates/inflation

The dollar was up two cents.  It continues to develop a very short term uptrend but on shrinking volume at a time that the long bond is getting hit hard.
GLD was down slightly, which it should be doing in a high interest rate, rising dollar scenario.

Bottom line: very short term, stocks are in a downtrend; long term, the trend is up.  Last week’s stomach churning volatility may raise some questions about whether the Market has hit a high; but so far the answer is no. 

The price action in the TLT, UUP and GLD continues to baffle me both as they relate to the equity market and to each other. 

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. 

With respect to the latter, any further changes in our Economic Model are dependent on (1) more follow through from corporate America increased spending on wage hikes and increased capital spending [as opposed to higher dividends, stock buybacks and executive compensation] and (2) the impact of the spiraling deficit.  Until I have a better handle on this, I am holding off on any increase in my 2018 growth outlook---which is putting me at odds with a generally more optimistic view from the Street.

That said, even if I am being too conservative, I don’t believe that a more rapidly improving economy justifies current valuations and may even exacerbate the real problem (in my opinion) facing the Markets---which is Fed policy/QE and the effect an inflationary impulse would have on its current ‘tighten as long as the Markets remain calm’ policy.  In other words, the need to control inflation may trump the best laid plans.  That is not my forecast, at least, at the present.  But if it occurs, it will be a carbon copy of every other time the Fed was forced to move aggressively against inflation because it waited too long to normalize monetary policy in the first place.

I want to reiterate the point that I don’t believe that a tighter Fed will cause a recession because QE did very little to help the economy.  Although it may act as 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.

The pin action this week may be indicating that investors are coming to that realization as (1) long term interest rates increase, (2) the latest monetary data out of the Fed indicates that it has been shrinking its balance sheet faster than its narrative suggests and (3) other central banks [save the BOJ] are sounding much more hawkish of late.  It is too soon to assume that investors are now worried about the consequences of unwinding QE; but at least we have a sign that it could be touching the periphery of their consciousness.                     

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 the chance that the effects of the tax bill 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/they 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.
                When things break (short):

DJIA             S&P

Current 2018 Year End Fair Value*              13860             1711
Fair Value as of 2/28/18                                  13315            1643
Close this week                                               24190            2219

* 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.