Saturday, February 17, 2018

The Closing Bell

The Closing Bell

2/17/18

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 Uptrend                                 23840-26316
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                                     2397-3168
                                    Intermediate Term Uptrend                         1251-3065
                                    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 weighed to the negative: above estimates: January housing starts, weekly jobless claims, February preliminary consumer sentiment, the January small business optimism index, the February Philly Fed manufacturing index, December business inventories/sales; below estimates: weekly mortgage and purchase applications, month to date retail sales, January retail sales, January industrial production, the February NY Fed manufacturing index, the January budget surplus, January CPI and PPI, January import/export prices; in line with estimates: the February housing market index.

  The primary indicators were also negative: January housing starts (+), January retail sales (-) and industrial production (-).  The call this week is negative.  Score: in the last 123 weeks, forty-two were positive, fifty-eight negative and twenty-three neutral.

We are now on a seven week roll in which the stats trend has been downbeat---following a brief period of very positive data.  As you know, I attributed the latter to a much better corporate response to the tax cut than I had anticipated.  However, since then (1) the initial surge in upbeat wage/cap spending announcements have tapered off dramatically and (2) as has the aforementioned trend in economic stats. 

I am not yet ready to return to my original assessment (that the tax bill was not fairer, simpler or pro-growth), but I am certainly leaning that way.  And it does appear that the brief period of above average growth may be attributable to the recovery activity from the earlier hurricanes and wild fires.  The longer we go without any sign of economic improvement from either the tax bill itself or the increase in individual/corporate psychology, the more likely I am to reiterate my first opinion.

Further, I think it important to note that many of the recently reported price/inflation numbers have shown an increase.  At the moment, the trend is too short to prompt any change in our inflation forecast.  However, I will be paying close attention to this data because of their implication for Fed policy.

I also want to make one important distinction.  There is little doubt that corporate earnings will advance markedly in 2018 as a result of the tax bill.  But that is not economic growth; it is simply a one-time improvement in the level of profits.  It won’t result in expanded economic growth unless those higher earnings are utilized to raise productivity versus being spent on dividends, buybacks and acquisitions.  Initially, it appeared as if the former was going to occur.  Now not so much.  The point being, don’t confuse a single year’s higher earnings with an increase in the secular growth rate of corporate profitability.

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 items in DC this week were the Donald’s new infrastructure bill (all talk and little do), his FY2019 budget (throwing a balance budget under the bus, but DOA), a proposal to increase the gasoline tax (the first sensible idea in a long time) and initial action to impose tariffs on Chinese cast iron soil pipe (if the numbers are correct, a reasonable step).  So there has been a lot to digest. 

All in all, the spending proposals create the potential for additional deficit spending; but at this moment, it is tough to figure the magnitude of any final package.  So it is too soon to suggest that the deficit/debt problem is going to get any worse than it already is.  In fact, if the gasoline tax is enacted, it would be a welcome addition to any infrastructure legislation.  Nonetheless, any increase in deficit spending would likely exacerbate the forces behind an inflationary impulse that may force the Fed to tighten much quicker and much further than it wants.

Finally, as you know, I am a big fan of free trade, so I take notice at the proposed action this week by the US against China on cast iron soil pipes.  That said, (1) I have no clue how big that market is; but if the worse happens, I don’t think that it would be earth shaking, (2) the action is an appeal to the international trade commission; so there is a litigation process that could deny the US claims and nothing would occur and (3) if the Chinese are selling this product as far below cost as the US claim suggests, this is probably a reasonable step to take.

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.  However, 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.  Nothing new this week.

(2)   fiscal/regulatory policy. 

The Donald was busy this week and not in a particularly positive way.  He released his infrastructure plan which had some sizzle [$1.5 trillion in spending] but little steak, to wit, only $200 million would come from the feds, leaving the rest to state and local governments [which are just as broke as the federal government but can’t print money] and private enterprise [which I assume won’t invest in anything that doesn’t economically benefit it].  That’s the good news.

The bad news is Trump also submitted his FY2019 budget which proposed more deficit spending with no pretense of being in balance in ten years.  That would only make containing higher interest rates or inflation harder.  There is a silver lining---virtually everyone has declared it dead on arrival.  Nonetheless, it is out there and something to be negotiated against; meaning with the end result of the Donald’s budget being more deficit spending, it leaves plenty of room for congress to argue over its content but still end up a higher deficit.

The Donald also suggested that he would approve an increase in the gasoline tax.  Since this is a ‘user’ tax, I think it makes a lot of sense as a source of funding for infrastructure spending---as long as it doesn’t serve as a rationale for more deficit spending.  That said, virtually the entire Washington establishment has poo pooed the proposal.

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 only news this week from the gurus in the Eccles Building was the speech by new Fed chief Powell at his swearing in ceremony in which he vowed to be alert to financial stability risks, i.e. the Fed will still have its eye on the Markets [even though there is no mandate to do so].

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, if there is an increase in inflation, 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 trashing the Markets. 

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

Another ear burner from Jeffrey Snider (medium and a must read):


(4)   geopolitical risks:  More 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] fourth quarter EU GDP was strong as was December industrial production; January UK inflation was above the BOE’s goal while retail sales were disappointing,

[b] fourth quarter Japanese was much stronger than anticipated.

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 initial unexpected positive corporate actions following the tax cut, I am, at the moment, a bit wary of pushing 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
         
  Technical

The indices (DJIA 25219, S&P 2732) were up slightly on Friday, finishing above both moving averages and within uptrends across all major timeframes.   Volume continues to drop (a bit concerning in a strong rally); breadth was positive.  The technical assumption is that long term stocks are going higher; though the Averages need to overcome their former highs before we have an all clear signal. 

The VIX was up, bouncing off a support level and remaining at an elevated level, suggesting that there is no end to the recent volatility.

The long Treasury inched higher, but still finished below both moving averages, in very short term and short term downtrends and very near the lower boundary of its long term uptrend, a breach of which would clearly intensify investors’ concern about rising interest rates/inflation

The dollar was up, having bounced off of a support level.  Nonetheless, it ended below both moving averages and in an intermediate term downtrend. This remains an ugly chart.
           
GLD was off slightly.  It had a good week, bouncing off a minor support level and leaving its chart in relatively good shape.
               
Bottom line: equity investors seem to have shaken off their concerns over higher inflation/interest rates as well as the weak economic data.  That suggests that they are assuming that the pickup in CPI and PPI will be short lived or contained and the poor numbers will keep the Fed accommodative---which I disagree with but could respect if not for the contrary behavior of TLT, UUP and GLD.  Their pin action notwithstanding, the technicals of the equity market point higher.

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, we have gone another week in which there were no major additional spending plans announced.  That doesn’t mean that we won’t see a further pick up in this kind of activity.  However, if we don’t, then I think the impact of the tax cut on the economy will not be enough to prompt an increase in my long term secular economic growth rate---which means I may not be as wrong about the tax bill’s impact as it appeared three weeks ago. 

To be clear, it will affect 2018 corporate earnings positively; but for the growth rate of those profits to accelerate, at least some of the funds must be directed at enhanced productivity.  And right now, I think that issue remains a question---meaning that while a one-time increase in profitability will result in a one-time increase stock prices (assuming a constant P/E), it will not increase the multiples (P/E’s) themselves or the rate of earnings growth.

The more important thing to focus on at the moment, is the overall effect of the tax bill, the short term budget agreement, the infrastructure plan and Trump’s FY2019 budget both on secular and cyclical growth and inflation.  Until I have a better handle on this, I am holding off on any increase in my long term growth outlook---which puts me at odds with a generally more optimistic view from the Street.  The key to that disagreement centers on how much growth versus how much inflation the aforementioned factors will generate.  My position is that the economy is too burdened with debt for there to be much real growth generated by these measures; and hence, the majority of any impact will be on prices.

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.

That said, the pin action this week tells me that opinion is at odds with the Market.   Having been chastened a bit by the initial corporate response to the tax bill, I recognize that I could be wrong on this contrarian view.

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) currently that effect appears to be dwindling, (2) if Trump follows through with his trade threats, and/or the deficit/debt continues to rise driven by the recently announced spending proposals, I believe that it/they would negate or, at least, partially negate any potential positive. More debt will inhibit not enhance growth and will likely create inflationary pressures which will have to be dealt with by the Fed, sooner or later.  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 2/28/18                                  13315            1643
Close this week                                               25219            2732

* 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.








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