Saturday, March 10, 2018

The Closing Bell


The Closing Bell

3/10/18

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                                 24087-26688
Intermediate Term Uptrend                     13057-29262
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2417-3188
                                    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 slightly negative: above estimates: month to date retail chain store sales, the February ADP private payroll report, February nonfarm payrolls, the February ISM nonmanufacturing index; below estimates: weekly mortgage and purchase applications, February retail chain store sales, weekly jobless claims, January wholesale inventories/sales, the January trade deficit; in line with estimates: the February Markit services PMI, December/January factory orders, fourth quarter productivity/unit labor costs.

  The primary indicators were slightly positive:  February nonfarm payrolls (+), December/January factory orders (0) and fourth quarter productivity/unit labor costs (0).  I was tempted to call the week a neutral but the overwhelmingly positive jobs report pushed me to the positive side.  Score: in the last 126 weeks, forty-three were positive, fifty-nine negative and twenty-four neutral.

This is only the second up week in the last nine; and it was just barely so.  And it does nothing to change my current thinking: the initial surge in economic activity following the tax bill was more likely attributable to post hurricane/wild fire recovery spending than the much touted jump in wages/cap ex spending. 

Just a note on that jobs report---it wasn’t just the headline number of stronger job growth that was positive (which would suggest a more aggressive tightening Fed).  It was also the expansion in the labor force participation rate coupled with the lack of wage growth.  In other words, employment is rising but largely due to the return of those dropouts that economists have been so gloomy about; and they are rejoining the labor force not because of higher wages but because of more jobs.  If that trend continues (i.e. rising employment, increased participation rate and stable wages) that would be a big plus for noninflationary economic growth and would cause me to raise my forecast for long term secular growth.  But this is one number.  More is needed before I would consider such a change. 

My favorite optimist on Friday’s jobs report (medium):

Still 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.  Clearly, 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 revert to my original opinion (Friday’s jobs report notwithstanding).

I do want to reiterate 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 was mixed at best.  This is the first bit of cognitive dissonance we have gotten in a while on the global outlook.  At this point, I have to view it as a one-off occurrence though clearly we have to be attentive to the potential of a change in trend.

The big item in DC this week was the Donald’s tariff theater in the round.  After much huffing and puffing, including the resignation of Cohn, the finale was simply an announcement, no action---that comes later it seems.  In essence, he told the world his intent, then gave most of it the opportunity to make him a better deal than the US now has.  Of course, that doesn’t mean that the US will get a better offer; but, at least, there is more reason to Trump’s approach to trade than first appeared.  The results of this ‘art of the deal’ strategy are still to be determined.

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.  However, it appears that the positive effects of the tax bill have quickly dwindled. Further, Trump’s approach to free/fair trade is stomach churning and while he appears more circumspect than originally thought, we still don’t know whether or not it will result in a trade war in the end.  At this point, our forecast remains economic growth at a slightly better long tem secular rate but still below historical standards.

       The negatives:

(1)   a vulnerable global banking system.  Congress is now attempting to roll back provisions of Dodd Frank, one of which will loosen the restrictions on large bank trading desks.  I needn’t remind you that this is the group of clowns that played a major role in the 2007 financial crisis and that to date, no one has been reprimanded, punished or gone to jail.  So I pose the question, why would they act any more responsible this time around?

(2)   fiscal/regulatory policy. 

The main focus this week was on trade; specifically, the Donald’s intent to impose tariffs on steel and aluminum imports.  Forgetting for a second the math as it pertains to this action, the more important issue as I posed it, is how this scenario plays out: [a] is Trump right about the extent of price cheating and that there will be little response, [b] is he about to start a real trade war or [c] is all this theater just part of the Donald’s ‘art of the deal’ negotiating strategy.

Despite the resignation of Gary Cohn, a  leading in-house advocate of free trade, and the apparent ascendancy within the administration of the pro-tariff crowd, Trump’s Thursday ‘proclamation’ appears to signal that he is much more rational on this issue than many [including me] may have thought.  In short, alternative [c] seems to be most likely outcome at this point.

You know my thoughts on trade---the freer, the better with the caveat that there are always cheaters that must to brought to task. 

The math of a trade deficit (medium and a must read):

The latest response from China (medium):

My bottom line: free trade is a significant economic positive, a fact that has been too well substantiated by history.  Any move toward a trade war would economically damaging to the US. 

Free trade versus capital flows (medium and today’s must read):

 I said nothing above about a huge concern of mine---the direction of fiscal policy; which is to say, higher spending and tax cuts at a time of historically high budget deficits and national debt. Again, you know my bottom line on this score also.  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. 

(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 released its latest Beige Book this week; the bottom line of which was that the economy was humming which is leading to upward pressure on wages and prices.  This sounded to me like an advance ad for, at the very least, a continuation of the unwinding of QE and perhaps a hint that a more aggressive policy is coming. 

In these notes, I regularly relay published data that scarcely portrays an economy progressing as well as the Fed Beige Book implies; and I have said repeatedly in these pages that I have no idea what information the Fed is using to glean its rather upbeat assessment of the economy.

Not that is going to matter in the end.  If the economy is doing as well as the Fed says, then it will most likely continue to unwind QE and perhaps at even a more aggressive rate than is currently forecast.  And if my current operating thesis is correct, then the unwinding of QE will also result in the unwind of the asset mispricing and misallocation that has gone hand in hand with QE. On the other hand, if the economy is not doing as well as the Fed says but the Fed continues to unwind QE, then it will make the unwind of QE all the more quick and intense.

In other central bank news, BOJ governor Kuroda hinted that the end of Japanese QE may be near; then when markets reacted negatively, quickly walked back his statement.  At a BOJ meeting two days later, he reemphasized the QE forever mantra.

Also, the ECB met and left rates unchanged.  In its formal statement, it did, however, drop language stating that it could increase QE if necessary---which gave it a slightly more hawkish tone.
     
The bottom line is that 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 trashing the Markets. 

(4)   geopolitical risks:  representatives from South and North Korea met this week.  In the process, the North Koreans claimed that they would be willing to denuclearize, if the country’s safety could be insured. Plus Kim Jong Un issued an invitation to Trump to negotiate a resolution to nuclearization versus safety problem---which he accepted.  It sounded oh so hopeful.  Just remember that we have heard this tune from North Korea before and look where it got us.  Furthermore, we have no idea how related this move is to the coming trade confrontation between China [North Korea’s primary sponsor and defender] and the US.

(5)   economic difficulties around the globe.  For the first time in a long time, the global economic data did not make for particularly good reading.  Given the strength of what has recently been reported, this is likely a hiccup. But it bears watching.

[a] the February EU composite PMI was below expectations; the February German trade surplus was larger than consensus but factory orders and industrial production were down significantly; February UK retail sales were below forecast but industrial production and factory orders were above,

[b] the February Chinese composite PMI came in lower than anticipated; February Chinese exports soared up 44.5% while imports rose 6.3%; February CPI was higher than anticipated while PPI was lower.

The bottom line remains the same: Europe gaining strength, Japan may be improving as is China, with the caveat that this week’s poor performance has been duly noted.
                       
            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.

This week’s turmoil on trade could prove to be a negative.  However, it appears that all the tough rhetoric was just part of Trump’s ‘art of the deal’ strategy.  Not that the US won’t end up in a trade war; but I think the probabilities of one are less than I did last Monday.

That leaves the larger issue (for me) which we know with certainty; that is, how will the tax cut, increased deficit spending and a potentially big infrastructure bill impact economic growth and inflation.  As you know, I have an opinion (bigger deficit/debt=slower growth; higher deficit spending=inflation).

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 bank has created a Hobson’s choice for itself: 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 25335, S&P 2786) responded enthusiastically to a near perfect jobs report.  They ended just short of their prior high; so, on Monday, I will be interested to see if they can close above that high or retreat. Volume was up, but not a lot and it remained at a low level.  Breadth improved slightly; certainly not as much as I would have thought.  Plus the flow of funds indicator looks poised to break an uptrend.  That said, the Averages are above both moving averages and within uptrends across all major timeframes. The technical assumption is that long term stocks are going higher.  However, the indices are now stuck in a narrowing range defined by lower highs and higher lows.  In addition, they need to overcome their former all-time highs before we have an all clear signal. 

The VIX fell another 11 ½ %, ending below the lower boundary of its short term uptrend for a second day; if it remains there through the close next Monday, the trend will reset to a trading range.   This pin action may be anticipating a drop in volatility, which would be a plus for stocks.
               
The long Treasury fell, apparently unimpressed with the jobs report or any increased likelihood of an easier Fed.  It inched closer to its only remaining support level (the lower boundary of its long term uptrend) which if breached, would clearly intensify investors’ concern about rising interest rates/inflation

The dollar was off fractionally, also seemingly unmoved by the jobs report.  It remains an ugly chart.
           
GLD was up slightly, also lacking the enthusiasm of stocks.  Though unlike TLT, it was in agreement with them. Momentum remains to the upside, but it must still overcome a very short term downtrend.
               
Bottom line: the technicals of the equity market point higher for the long term; very short term, we should get more information on Monday with the Averages poised to either challenge their prior high or bounce off it.  TLT, UUP and GLD didn’t get jiggy with the jobs report and TLT even pointed at no change in Fed policy (unwinding QE).
           
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.  Unfortunately, the recent decline in the strength of economic activity suggests that any benefit from enhanced corporate spending stemming from the tax bill was short lived.  Further, if Trump’s move in raising tariffs proves too aggressive, this would likely have an adverse impact on growth.

This week we added a potential trade war to the worries regarding 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.  With regard to the former, it appears that much of Trump’s bluster was intended to elicit the best offer possible in adjusting steel/aluminum prices from our trading partners---not the hell bent rush to impose tariffs that it initially appeared to be.

  With respect to the latter, my concern remains on how much growth versus how much inflation the aforementioned factors will generate.  As you know, 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, the near perfect jobs report under mines that notion.  But it is only one number; so I need more along that line me to alter my position.

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 improved growth.  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.

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.  That math is simply: 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 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 3/31/18                                  13375            1650
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.