Saturday, June 9, 2018

The Closing Bell


The Closing Bell

6/9//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                     13307-29512
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2531-3302
                                    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 was meager and slightly positive: above estimates: weekly mortgage and purchase applications, weekly jobless claims, wholesale inventories/sales, May services PMI, May ISM nonmanufacturing index; below estimates: month to date retail chain store sales, April consumer credit, April factory orders, first quarter nonfarm productivity and unit labor costs; in line with estimates: none.


However, both primary indicators were negative: April factory orders (-) and first quarter productivity and unit labor costs (-).   I rate this week negative. Score: in the last 139 weeks, forty-seven were positive, sixty-five negative and twenty-seven neutral.

So there was really no follow through to last week’s extremely upbeat data series although that could simply be a function of lack thereof.  Therefore my conclusion hasn’t changed.  ‘While it is too soon to be considering a revision in our forecast, it (last week’s data) could be signaling an improvement in the growth rate of the economy.’

Overseas, the stats were negative, which is basically in line with the dataflow for the last couple of months.  Certainly nothing to provide much hope that the ‘global synchronized growth’ scenario is resurrecting

How the trade negotiations with the EU, NAFTA and China conclude is probably the most important economic unknown at the moment---because of its potential impact on the long term secular growth rate of the economy.  The rhetoric has certainly not been positive; but that is all part of the negotiating process, especially where the Donald is concerned.  That said, China appears to be trying to reach an accommodation with the US; and we will know more about any progress with the EU and NAFTA by the end of the G7 meeting.   I stand by my bottom line that it is far too soon to be talking trade war.  For the moment, all we can do is observe.

The international political news was mixed.  The US/North Korea summit is on for next week (at least for the moment) and Trump continues to play hard ball with Iran.  I have no idea how the latter is going play out; but I can think of more negative than positive outcomes.

 Meanwhile, the Trump/Mueller/Stormy Daniels/Russia brouhaha just keeps getting more convoluted as now the Hillary email scandal is back in the mix.  I have no idea where this whole thing ends up; but at this moment, it is becoming an increasing distraction from the business of the state.  Mostly, that is a good thing.  The more time our ruling class indulges in self-flagellation, the less time it has to screw with you and me.  My concern is that this ends in another impeachment circus which historically has never been good for the Markets.’

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 notion that the economy is losing steam might have been called into question two weeks ago.  However, there was little back up evidence this week; though as I noted, there wasn’t a lot of data to confirm or disprove it.  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 as long as you don’t count the damage that [a] would be done to the EU banking system by a crisis in Italy and [b] is now apparently being done to some emerging market economies by a dollar funding shortage,
                       
I thought I would include this gem on bank regulators (medium):

(2)   fiscal/regulatory policy. 

Senate leader McConnell surprised us all and stated that the senate would remain in session through the end of summer in order to address ‘the peoples’ business’.  Leaving aside the political motivation for this move, it would be positive if a large number of Trump judicial nominees could be approved.  On the other hand, there is a number spending measures on the GOP agenda; and, in my opinion, that last thing the country needs right now is more spending.

As I noted above, while China appears to be trying to compromise, the trade discussions with NAFTA and the EU got very acrimonious heading into the G7 meeting on Friday.  Though as I also noted, given Trump’s ‘art of the deal’ style of negotiating, I am not taking the rhetoric at face value.  Further, I also believe that Trump has a point that some provisions of the current agreements need to be changed to fit the current reality.  So I don’t see this process as a negative, though I am not giving the Donald a lot of style points.  The bottom line is that a trade war would be a huge negative but a restructured trade regime that is fairer to the US would be a plus for the long term secular growth rate of the country.


While a trade war would be a significant negative for the economy, the more immediate problem is too much national debt and too large a budget deficit which could potentially be made all the worse if the GOP senate pushes though additional spending measures this summer.

(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.  

Two developments this week:

[a] the EU central bankers confirmed that the ECB will be discussing ending its massive bond buying program at its upcoming meeting.  I don’t view that as being particularly meaningful since {i} discussing is not acting and {ii} these guys have a worse history of transitioning from easy to tight money than the Fed.  So I doubt that anything really newsworthy will come out of this meeting.

Speaking of which, our group meets this coming week and expectations are for another rate hike.  However, the important thing coming out of that meeting will the narrative in the subsequent statement and the press conference with Powell.  Here is a preview:

And speaking of the Fed narrative, here is another example of how it assumes that it knows more than the Markets (medium):

[b] far more important, the central banks of India and Indonesia pleaded with the Fed to halt its tightening process because of its impact on their economies {since (1) much of the emerging markets economic growth is dependent on exports and (2) their international trade is conducted in dollars, the growing shortage of dollars resulting from the Fed tightening as well as the increased level of Treasury requirements to fund the US deficit is having an adverse effect on trade and its financial system}.

And:

Finally, the risks of a potential trade war, the dollar funding problems in emerging markets and the political unrest in Italy and Spain pose a threat to functioning of the global financial system, in general, and the solvency of the EU banking system, in particular.  

Adverse developments in either the emerging markets or the EU would likely slow, halt or even reverse the current Fed tightening policy.  I continue to doubt the effectiveness of QE in stimulating US growth so any suspension of QT, in my opinion, will have little economic impact.  On the other hand, if the Fed continues to tighten it could lead to big problems in the emerging market economies.
                       

(4)   geopolitical risks: 

[a] the North Korea/US summit is on for the moment.  An agreement that would dismantle the North Korean nuclear program would be a big plus.  The questions are {i} what do they want in exchange? and {ii} will they adhere to any agreement given their history of abrogating every treaty that they ever signed?  Stay tuned but don’t get jiggy,

[b] more important is the standoff between Iran and the US since it involves the entire Middle East geopolitical sphere as well as the ongoing trade talks with the EU.  I have no clue where this thing goes; but like Woody Hayes once said, ‘I have three choices and two of them are bad’,

[c] the change in the Italian government has the potential to cause problems for the country, its banking system, the EU banking system and the viability of the political structure of the EU.  Not that any of these things will occur.  But we have to be aware of them as threats to the global economy.

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

 [a]  first quarter EU economic growth and April retail sales were well below expectations; May EU composite PMI was in line while the UK service PMI was better than anticipated; April German factor orders and industrial production were disappointing,

[b] May Chinese composite and services PMI’s were in line while its trade balance fell,

[c] May Japanese composite PMI was below estimates and first quarter GDP declined.

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.

The hope posed by last week’s dataflow was dampened by this week’s unremarkable numbers.  While it still could be a sign that the corporate tax cut is starting to impact economic growth, the burden of proof remains on the optimists.

So until otherwise proven wrong, 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.  I believe that a bigger deficit/debt=slower growth and a higher deficit spending=inflation, even if they are the result of a tax cut and/or infrastructure spending.  Hence, this is a negative for the long term secular growth rate of the economy.  The degree to which these opposing forces offset each other is the $64,000 question to which I currently have no answer.

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 25316, S&P 2779) traded higher yesterday.  Volume declined; breadth improved but is moving into overbought territory.   The Dow finished above its 100 day moving average for a third day, reverting to support.  The S&P ended above its 100 day moving average (now support).  Both remained 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 resistance offered by the 100 day moving average now appears to be in the rear view mirror, clearing the way for a challenge of the indices former highs.  Longer term, the assumption is that stocks are moving higher.
               
                The VIX rose fractionally, but still finished below its 100 and 200 day moving averages (now resistance) and below the upper boundary of its short term downtrend.  This continues to point to higher stock prices; though it is at a level at which institutions start buying it as portfolio insurance.

The long Treasury was off slightly.  While it remains above its 100 day moving average and the lower boundary of it long term uptrend, it has lost the upward momentum from mid-May and is within a point of challenging both support levels.  A break of the latter would end a twenty year plus bull market and indicate that higher interest rates are in our future.

The dollar was up fractionally.  Though it has voided its very short term uptrend, it still has plenty of upside momentum, being well above both moving averages and it is in a short term uptrend.

GLD was up slightly but remained below its 100 and 200 day moving averages.  However, it closed above the upper boundary of its short term downtrend by virtue of having traded flat for the last three weeks as the downtrend continued.  If it remains there through the close next Tuesday, it will reset to a trading range.
               
Bottom line:  the pull of the indices’ 100 day moving averages is now yesterday’s story.  The next resistance level is their all-time highs (26656/2874) which I am assuming that they will at least challenge.  Both TLT and UUP are pointing at an improving economy and higher interest rates.  GLD isn’t really telling us much.

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---save for the previous week’s stats.  However, in my opinion, the financing burden now posed by the massive US deficit and debt has and will continue to constrain growth.  Until the numbers show some consistency to the upside, the burden of proof remains on those in the positive camp,

(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,

(3)   the rate at which the Fed unwinds QE.  The optimists believe that it will tighten only to the extent as to not disrupt the Markets.  That assumption may be about to be tested as dollar funding issues in the international economy are starting to bite.  If this situation worsens, the Fed will be faced with the alternatives of either easing to help the emerging markets and risk rising inflation or keep tightening and trash the emerging markets’ economies.

I have maintained all along that given the Fed’s overly aggressive pursuit of QE, it would sooner or later be presented with a Hobson’s choice.  Now it is stuck with the need to reduce the massive liquidity injection it made into the US/global financial system as the first visible negative consequence of tightening is becoming manifest.  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                                               25316            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.