Saturday, June 23, 2018

The Closing Bell


The Closing Bell

6/23/18


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                     13350-29555
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2548-3319
                                    Intermediate Term Uptrend                         1285-3100
                                    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 was mixed: above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, weekly jobless claims, first quarter trade deficit; below estimates: the June housing market index, May existing home sales, the June Philly Fed index, May leading economic indicators; in line with estimates: May housing starts/building permits, the June flash composite, manufacturing and services PMI’s.

However, the primary indicators were negative: May housing starts/permits (0), May existing home sales (-) and May leading economic indicators (-).   Based on that, I rate this week negative. Score: in the last 141 weeks, forty-eight were positive, sixty-six negative and twenty-seven neutral.

The data continues to provide both positive and negative signals; the last couple of weeks being a perfect example.  It is 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 not overwhelming, (2) in the background is the current high and rising level debt in all economic sectors.  I am not sure how long the recent growth spurt can last with this overhanging burden and (3) 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. 

Trade remains front and center on the economic stage.  The lead headlines this week were tariff threats---lots of them.  As you know, I agree with Trump’s objective which is a fairer trade regime though his style could be less bellicose.  Indeed, my fear is that latter could hamper or negate the former.  So at the moment, the risk is some sort of trade war---which would be a detriment to economic growth. On the other hand, a positive result would be a plus for the long term secular growth rate of the US.

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.  Unfortunately, the reverse would also be true.  In addition, 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.  

       The negatives:

(1)   a vulnerable global banking system.  Deutschebank did it again.  This time announcing a heretofore undisclosed major loss in its trading operations.  This illustrates perfectly my objection to the rules applying to the major bank’s prop trading desks.  As long as the traders have big upside [bonuses] and no downside [shareholders/taxpayers eat the losses], this situation is not going to improve.  Somebody has to be fined severely or go to jail or both before this risk to bank balance sheets [solvency] is removed.     

(2)   fiscal/regulatory policy. 

Trade issues consumed this week’s headlines.  It included lots of fiery rhetoric but some hopeful signs that our trading partners may be willing to negotiate.  I can’t add anything to what I have already said.  But I will repeat my bottom line: I believe that Trump is attempting to reset the post WWII political/trading regime which has grown increasingly disadvantageous to the US; and I think that he is right to do so.  Though he is woefully short on style points.  If successful, it will be a plus for the long term secular growth of the US economy. If a trade war results, there will be pain.

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.  

This week the Bank of England followed up the four central bank meetings last week.  It left rates unchanged.  However, its narrative was more hawkish than expected.  As a result, the odds of an August rate hike increased.  It left its bond buying program intact. 

So the demise of global QE took another baby step toward a well-deserved end.  My thesis remains that {i} QE 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 its unwinding will not be Market friendly.

(4)   geopolitical risks:  North Korea, Iran and Italy; but little news on any this week.

(5)   economic difficulties around the globe.  Not a lot of stats released this week.  But what we got was upbeat; and it was from the EU which has been the source of much of the negative dataflow over the last couple of months: the June flash EU composite PMI was 54.8 versus estimates of 53.9; manufacturing was 55.0, in line; and services was 55.0 versus 53.7.

Other developments included:

                  Growing political turmoil within the eurozone (medium):

                  OPEC raises its production limits by 600 thousand B/D (medium):
           
            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. (must read):

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.

The Market-Disciplined Investing
         
  Technical

The Averages (DJIA 24580, S&P 2754) recovered a bit on Friday---not really surprising given their dramatically oversold condition.  Volume rose; breadth improved.  The Dow finished below its 100 day moving average for a third day, reverting to resistance while the S&P remained above (now support).  Both ended above their 200 day moving averages (now support).  The Dow is in a short term trading range, the S&P in a short term uptrend. 
               
                The VIX declined 6 ½ %, closing below its 100 day moving average (now resistance), back below its 200 day moving average (voiding Thursday break) and within a short term trading range.  It looks like it bottomed in early June. 

The long Treasury fell pennies, closing above its 100 day moving average and the lower boundary of its long term uptrend but below its 200 day moving average and remained in a short term downtrend.  It seems trapped in the range defined by those indicators.

The dollar was down fractionally, but still ended well above both moving averages and in short term and very short term uptrends.

Yes Virginia, gold can go up, but still finished below its 100 and 200 day moving averages and in a short term downtrend.
               
Bottom line: we got a bit of cognitive dissonance on Friday as the Dow’s 100 day moving average reverted to resistance while both it as well as the S&P’s 100 day moving average are rolling over and heading for a cross of their 200 day moving averages.  If that occurs, it would also be a negative technical signal.  However, the longer term momentum remains to the upside; so it is too soon to become negative much less alter my assumption that long term stocks are going up.

On the other hand, bonds and the dollar again traded at odds with each other; and gold is declining no matter what the news or the pin action in other indicators. In short, we are getting no directional information from these indices.

                Friday in the charts (medium):

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 should 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 economic as well as profitability 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 earnings growth.  However, the reverse 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.

Bottom line: a new regulatory regime plus an improvement in our trade policies should have a positive impact on secular growth and, hence, equity valuations.  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. (must read):

                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                                               24580            2754

* 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.