Saturday, June 16, 2018

The Closing Bell


The Closing Bell

6/16/18


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 Trading Range                      21691-26646
Intermediate Term Uptrend                     13325-29530
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2539-3310
                                    Intermediate Term Uptrend                         1281-3096
                                    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 a slight upward bias to equity valuations.   The data flow this week positive: above estimates: May retail sales, month to date retail chain store sales, weekly unemployment claims, the June (preliminary) consumer sentiment, May small business optimism index, April business inventories/sales, NY Fed manufacturing index; below estimates: weekly mortgage and purchase applications, May industrial production, May PPI, the May budget deficit, May import/export prices; in line with estimates: May CPI.


However, the primary indicators were mixed: May retail sales (+) and May industrial production (-).   Based on volume, I rate this week positive. Score: in the last 140 weeks, forty-eight were positive, sixty-five negative and twenty-seven neutral.

The data continues to provide both positive and negative signals---something to be expected in an economy that is growing but is laboring to do so.  There is no question that the overall second quarter numbers have shown a pick up from first quarter; and if that trend continues well into the third quarter then I will likely raise our 2018 growth forecast. 

Holding me back from doing that right now is (1) we don’t know how enduring the improvement in the second quarter stats are.  They were almost certainly impacted by the tax cuts; but given the current high and rising level debt in all economic sectors, I am not sure how long the spurt of optimism can last and (2) the outcome of trade negotiations could have a significant effect on growth.  The uncertainty around this issue is currently higher than it should be; but it is there nonetheless.  My conclusion hasn’t changed.  ‘While it is too soon to be considering a revision in our forecast, it (the recent data) could be signaling an improvement in the cyclical growth rate of the economy.’

Overseas, the negative stats continued. Clearly nothing that is a plus for the US economy.

The trade negotiations turned into a food fight with the US imposing or threatening to impose tariffs on all on major trading partner and vice versa. I covered this extensively last week so I won’t repeat myself except for the bottom line: a trade war represents a significant risk to the long term secular growth of the US and our trading partners.  On the other hand if this is precedent to a new trading regime more reflective of current economic/political realities (which by the way I would applaud), then it will be a plus--- though getting there could cause some heartburn.

The international political headlines were upbeat, trumpeting an historic deal with North Korea.  Unfortunately, this was basically ‘a letter of intent’ with no promises made.  I keep coming back to the historic pattern of the North Koreans which is to feign agreement then renege later.  My guess is that it will be a long time before we know whether or not this a positive.

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 raised that growth forecast. There is the potential that Trump’s trade negotiations could also lead to an improvement in our long term secular growth rate---though that has yet to be determined.  On the other hand, the tax cut and spending bills, as they are now constituted, are negative for long term growth (you know my thesis: at the current high level of national debt, the cost of servicing the debt more than offsets any stimulative benefit) and could potentially offset any positives from deregulation and trade.

On a cyclical basis, the second quarter numbers are going to be better than the first, though there is insufficient evidence at this moment to indicate a strong follow through.  So my current assumption remains intact---an economy struggling to grow.  (must read):

       The negatives:

(1)   a vulnerable global banking system.  Nothing new this week except (must read):


(2)   fiscal/regulatory policy. 

The principal news this week was on trade, starting with the G7 meeting and then evolving into a tariff threat extravaganza.  You know my bottom line.  But for the moment I want to step back a bit and take 30,000 foot view of what I think Trump is trying to do. 

It is easy enough to attribute the goings on to the Donald’s ‘art of the deal’ strategy.  And certainly that is involved.  But I think that there is more happening than just a trade negotiation.  In my opinion, Trump is attempting to recast the post WWII economic paradigm.  For seven decades, the accepted model was for the US to provide a defense umbrella for Europe and Japan and fund their economic convalescence, part of which was allowing trade protection for their recovering industries. 

Well guess what?  That show is over.  The US rebuilt Germany, it reunified it, the German economy is smoking yet it doesn’t pay for a reasonable portion of the burden of its defense; and it is pissing and moaning about a trade regime that is more balanced. 

Don’t even get me started on France. 

Mexico wants the US to build plants to employ its burgeoning population and for those that it can’t get a job, it wants the US to take them in, give them a job plus health care and schooling so that they can send money back home instead of spending it here. 

China has been stealing our intellectual property for decades and no one has had the balls to make a stand. 

There is something wrong with this picture.  And I believe Trump is trying to correct some of the inequities.  Chances are that he won’t get it all right; and the process will be painful.  But it will be a start and that is better than nothing.

Unfortunately, this says nothing about an equally big problem to which Trump has contributed: too much national debt and too large a budget deficit which will usurp investment dollars that would otherwise be used for increased productivity.

(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.  

Four central banks met this week.

[a] the Fed: raised rates ¼ %, indicated that there were two more increases coming in 2018 and stated that its balance sheet will continue to shrink on schedule.  I covered this in Thursday’s Morning Call, so I won’t be repetitive except for the bottom line: not likely a negative for the economy but may prove to be the trigger for the unwinding of asset mispricing and misallocation.  Indeed, my thesis has always been that the Fed has waited far too long to unwind QE,

[b] the ECB: not only did it leave rates unchanged but it extended the time period for any hike.  However, it also said that it will decrease its bond purchases beginning in September 2018 and end them in December 2018 though it will continue to reinvest the proceeds of maturing bonds.  Markets read the lack of a rate hike as dovish; however, I think the ending of its bond purchase program is more important because it has been the excess liquidity spawned by global QE that has led to the massive mispricing and misallocation of assets.  This would be another step in correcting that costly experiment.
                 
[c] the Bank of China: markets were expecting a rate hike which didn’t happen, apparently out of concern over slowing economic growth---which many believe is the result of a tightening of credit {liquidity}.  Meaning the Chinese too are shrinking money supply,
                
[d] the Bank of Japan: left interest rates unchanged and failed to mention its bond buying program.  There had been indications that it might be allowing its balance sheet to shrink.  So far there hasn’t been any substantiating evidence.  So I am not sure what the absence of comment means, if anything.

So ever so slowly, global QE is coming to a well-deserved end.  My thesis remains that {i} it did little to assist the economic recovery following the financial crisis; so it is unlikely to be a major negative as it winds down. But {ii} it created a massive mispricing and misallocation of assets; and that will be impacted.

Part and parcel of that end is the funding problems that arise in foreign countries and marginal business (misallocation of assets) because the Treasury is now having to sell {i} all the bonds that the Fed isn’t buying, {ii} all the bonds that the Fed is not reinvesting in and {iii} all the bonds it needs to fund the growing budget deficit.  That is taking a lot of liquidity out of the Markets; and as the budget deficit grows and the Fed unwinds its balance sheet, even more liquidity will be absorbed.  At some point, some company, some bank or some country will be unable to finance or refinance its debt and the repricing of risk will begin in earnest.

                  The central bank party is already over (medium):

(4)   geopolitical risks: 

[a] the North Korea/US summit produced a lot of splashy headlines but few results, unless you count the promises of Un---which I don’t.

[b] the new Italian PM basically backed off any threat to leave the EU.  That eases tensions somewhat but does not solve that country’s bank solvency problem.  As I have noted before, because so many of the EU members’ central banks own the paper of other EU members, an Italian banking crisis would not be limited to just Italy.  That said, the ECB is second only to the Bank of Japan in its willingness to throw unparalleled amounts of liquidity to any country that would endanger the EU banking system.


(5)   economic difficulties around the globe.  The international data this week was negative.

 [a] April UK and EU industrial production were terrible; May UK CPI hit a one month low; June German investor sentiment declined,

[b] May Chinese industrial output, fixed asset investment and retail sales were   disappointing,

In short, the much heralded global synchronized expansion is yesterday’s story; its importance being the lack of any positive contribution to US growth.

            Bottom line:  the US long term secular economic growth rate could improve based on increasing deregulation.  In addition, if trade negotiations with China, NAFTA and the EU prove successful then a fairer trading regime would almost certainly be an additional plus for the US long term secular economic growth rate.  ‘If’ remains the operative word; plus we need to see the shape of any new agreement before changing our forecast. 

At the same time, those long term positives are being offset by a totally irresponsible fiscal policy.  The original tax cut, a second proposed new improved tax cut, increased deficit spending and a potentially big infrastructure bill will negatively impact economic growth and inflation, in my opinion.

On the other hand on a cyclical basis, growth in the second quarter will be above that of the first quarter, helped along by the tax cuts.  The issue for me is the strength of follow through.  Until more evidence proves otherwise, my thesis remains that the current level of the national debt and budget deficit are simply too high to allow any meaningful pick up the long term secular economic growth.

It is important to note that the negative impact that a rapidly growing national debt and budget deficit have on economic growth is not just fiscal in nature.  There is also an effect on Fed policy (via the increase in interest rates) which has its own problem extricating itself from its irresponsible venture into QE.  Part of that problem is the growing dollar funding issue in the emerging markets which could lead to further damage to global growth as well as the international financial system.


The Market-Disciplined Investing
         
  Technical

The Averages (DJIA 25090, S&P 2779) had a volatile day (not unusual for a quad witching Friday) ending down.  Volume was huge (also not unusual for a major expiration day); breadth was negative.  Both finished above their 100 and 200 day moving averages (now support).  The Dow is in a short term trading range, the S&P in a short term uptrend.  Longer term, the assumption is that stocks are moving higher.
               
                The VIX surprisingly declined 1 % (it is usually up on a down Market day), ending below its 100 and 200 day moving averages (now resistance) and in a short term downtrend---suggesting better times for stocks. 

The long Treasury was up slightly, finishing above its 100 day moving average and the lower boundary of its long term uptrend but below its 200 day moving average and in a short term downtrend.  Its pin action over the last two days seems to indicate that the turmoil in trade is driving investors to it as a safety trade.  That said, to achieve any additional upside momentum, it is facing the aforementioned resistance levels.  

The dollar was down pennies, closing well above both moving averages and in a short term uptrend.  Like TLT, it seems to be currently acting as a safety trade.

On the other hand, GLD, which has long been a safety trade, got pulverized, ending below its 100 and 200 day moving averages and below the lower boundary of its newly reset short term trading range.  I have no explanation for this performance.

Bottom line: trade worries appeared foremost in all investors’ minds on Friday; although GLD’s action totally confuses me.  That said, I think stocks held very well, while TLT and UUP didn’t exhibit frantic buying.  After a week heavily ladened with important economic developments, much of them negative, the price action in stocks suggest more upside.

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’ is being positively impacted based on a new set of regulatory policies which would lead to improvement in the historically low long term secular growth rate of the economy.  A further increase could come if Trump’s drive for fairer trade is successful.  On the other hand, a soaring national debt and budget deficit are negatives to long term growth and, hence, ‘Fair Value’.

At the moment, the important factors bearing on corporate profitability and equity valuations are:

(1)   the extent to which the economy is growing.  The optimists are out there; but to date they have questionable support, in my opinion, from the reported data.  To be sure, the second quarter numbers will look better than the first.  But follow through is important.  Until the stats show more consistency to the upside, the burden of proof remains on those in the positive camp. My thesis remains that the financing burden now posed by the massive US deficit and debt has and will continue to constrain growth,

(2)   the success of current trade negotiations.  If Trump is able to create a fairer trade regime, it would almost certainly be a positive for secular growth.  However, the converse is also true; and at the moment, the outcome is becoming increasing uncertain as tariff threats fill the air,

(3)   the rate at which the global central banks unwind QE.  The optimists believe that they will tighten only to the extent as to not disrupt the Markets.  Of course, the Markets haven’t been disturbed yet.  But with the global funding needs growing [more supply] and the US, ECB and China central banks tightening [less demand], it may not be that long before that occurs.  The question is, when it does, will it be too late to stop the repricing of risk.

I have maintained all along that given the Fed’s [and other central banks] overly aggressive pursuit of QE, it would sooner or later be presented with a Hobson’s choice: continue to unwind QE in the face of the financial difficulties of marginal borrowers or reverse it and create even more parasites for the economy to support.  I continue to believe that at some point the Fed will have no good alternative to tightening and when that occurs, so does the unwind of asset mispricing and misallocation.

Bottom line: a new regulatory regime plus an improvement in our trade policies should have a positive impact on secular growth.  On the other hand, I believe that fiscal policy will have an opposite effect on economic growth.  Making matters worse, monetary policy, sooner or later, will have to correct the mispricing and misallocation of assets---and that will be a negative for the Market.

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 simple: 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 any price strength to sell a portion of my winners and all of my losers.
               
                As a reminder, my Portfolio’s cash position didn’t reach its current level as a result of the Valuation Models estimate of Fair Value for the Averages.  Rather I apply it to each stock in my Portfolio and when a stock reaches its Sell Half Range (overvalued), I reduce the size of that holding.  That forces me to recognize a portion of the profit of a successful investment and, just as important, build a reserve to buy stocks cheaply when the inevitable decline occurs.

DJIA             S&P

Current 2018 Year End Fair Value*              13860             1711
Fair Value as of 6/30/18                                  13600            1677
Close this week                                               25090            2779

* 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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