Saturday, July 28, 2018

The Closing Bell


The Closing Bell

7/28/18


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                     13488-29683
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2581-3352
                                    Intermediate Term Uptrend                         1295-3109                                                          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 slightly negative: above estimates: month to date retail chain store sales, weekly jobless claims, July consumer sentiment, the July Richmond Fed manufacturing index; below estimates: June existing home sales, June new home sales, mortgage/purchase applications, June durable goods orders, the June trade deficit; in line with estimates: the May/June Chicago Fed national activity index, the July flash PMI’s, second quarter GDP.


However, the primary indicators were very negative: June new home sales (-), June existing home sales (-), June durable goods orders (-) and second quarter GDP (0).     So I rate this week a negative. Score: in the last 146 weeks, fifty were positive, sixty-nine negative and twenty-seven neutral.

A note on the GDP number.  Yes, it was good (+4.1%) and hence a positive. But the universe knew that it would outpace the first quarter reading.  However, it was below consensus (+4.2%) and didn’t come close to the 5% whisper number.  In addition, the GDP deflator was well above estimates which is sure to keep the Fed on the track of raising rates and unwinding its balance sheet.   Finally, there were a number of unusual one off numbers related to exports and inventories which will likely materially impact subsequent revisions.

So the economic data continues to provide both positive and negative signals---there is no consistent trend at all.  While the second quarter GDP read was definitely better than first quarter, I don’t believe that it points to a US economy that is now experiencing some kind lift off. 

No significant stats from overseas this week; but the overall trend continues to suggest that the ‘synchronized global expansion’ theme is over; and that means our own economy loses that as a tailwind.

The ECB met this week and reaffirmed its intent to leave rates unchanged at least thorough 2019 but to begin unwinding is QE at the end of this year.  In addition, the Bank of Japan is providing a few laughs as it attempts to obfuscate its goal to begin tightening. Meanwhile, the Chinese are pumping money into their financial system in an effort to stave off the negative consequences of a potential trade war with 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, while the second quarter numbers were definitely better than the first, 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.  

Loan covenant protection is at the weakest level in a decade (medium and a must read):


(2)   fiscal/regulatory policy. 

This week, trade remained center stage:

[a] of course, the number one item was the cease fire between the US and EU.  Lots of promises were made but no concessions.  The good news is that this puts an end, at least temporarily, to all the saber rattling.  Hopefully, it will lead to a meaningful reorientation of this trading regime.  ‘Hopefully’ being the operative word.

More cognitive dissonance (medium):                                                                 

[b] with respect to the Chinese, they insisted that they weren’t devaluing their currency {yeah, right} but began an aggressive expansion of fiscal policy which {like the devaluation that they supposedly aren’t doing} is designed to offset the effects of increased tariffs.  They also appear to be considering boycotting US branded products,

Trump responded by announcing subsidies to those products being impacted      by Chinese tariffs {which as I pointed out in Wednesday’s Morning Call means that he is now taxing consumers to subsidize the negative effect of his trade policy which were supposed to lower consumer prices}.  However, the largest factor in reaching some accommodation with the Chinese may be the threat of a new trading relationship between the US and EU which would target some of China’s more egregious trade policies,
    
As you know, I believe the outcome of current trade negotiations are an important variable in our long term secular economic growth rate forecast.  This week’s US/EU announcement is hopefully a signal that the Donald’s ‘art of the deal’ negotiating style is starting to pay off and that his attempt to reset the post WWII political/trade regime will succeed.  However, as I noted above, right now all there is, is hope.  We need to see concrete results before getting jiggy about the potential growth benefits of a fairer trade system.

Unfortunately, none of this says anything 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.  And that only got worse this week as the house is preparing another budget busting appropriations bill.
                
(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 remains on course to raise interest rates and unwind its balance sheet, at least until those policies start effecting the economy [Markets?].

The ECB met this week, left rates unchanged and reiterated that it would begin unwinding its version of QE in December 2018. 

Japan continued to struggle with how it might begin a tightening process but make it appear as though it isn’t---with little luck to date. 

On the other hand, the Chinese are aggressively expanding both monetary and fiscal policies in an attempt to offset the blow that US tariffs will deal to their economy.  Ultimately, though, that too will have to end.  Chinese companies and citizens are already highly leveraged with lots of very risky debt.  Adding to that burden will only exacerbate China’s liquidity and solvency issues.

However, short term that means that there is a growing divergence in major central bank monetary policies.  I am not smart enough to know how this ends, but it will almost surely introduce more volatility in the global economies/inflation as well as the Markets.  

If you believe, as I do, that ending QE will cause little economic impact but major pain for the Markets, this is not great news.    

(4)   geopolitical risks:  since political risk is so tightly enmeshed with the trade negotiations, it seems impossible to separate the two [i.e. North Korea with China, immigration with Mexico and NATO funding with the EU].  About the only thing I can say is that the risks are higher than before Trump started down his current path. 

In addition, the saber rattling between the US and Iran is escalating---the most immediate economic threat being a sizable reduction in oil supplies to the world.


(5)   economic difficulties around the globe.  No notable stats released this week.

            Bottom line:  on a secular basis, the US long term economic growth rate could improve based on increasing deregulation.  In addition, if Trump is successful in revising the post WWII political/trade regime, it would almost certainly be an additional plus for the US long term secular economic growth rate.  ‘If’ remains the operative word; though clearly this week’s developments with the EU improve the odds of a favorable outcome.

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.  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 in long term secular economic growth.

Cyclically, growth in the second quarter sped up, helped along by the tax cuts.  At the moment, the Market seems to be expecting that acceleration to persist.  I take issue with that assumption, based not only on the falloff in global activity but also the lack of consistency in our own data and the never ending expansion of debt.

The Market-Disciplined Investing
         
  Technical

The Averages (DJIA 25451, S&P 2818) sold off---not surprising in that they were in overbought territory.  Volume was up but breadth weakened.  However, the Dow continued to trade above its 100 day moving average (now support), above its 200 day moving average (now support), within a short term trading range and above its June high.  The S&P ended above both moving averages and in uptrends across all timeframes.  With the indices now in sync, the assumption is that they are on their way to challenging their all-time highs.

VIX jumped 7 ½% but remained below both moving averages and in a narrow trading range near the lower boundary of its short term trading range.  But it doesn’t seem to want to challenge that lower boundary.

The long Treasury was up slightly, bouncing off the lower boundary of its long term uptrend and its 100 day moving average, negating Thursday’s break.  It remained below its 200 day moving average (now resistance) and caught between the declining upper boundary of its short term downtrend and the rising lower boundary of its long term uptrend; though, at present, it is closer to the latter and it is losing technical strength.  A break of this developing pennant pattern has directional import.
           
            The dollar was off pennies, finishing above both moving averages and in a short term uptrend.  Further indications of strength are (1) its 100 DMA trading above its 200 DMA and (2) UUP has now made two higher lows.
           
            Gold was up slightly.  It closed below both moving averages (its 100 day moving average has now crossed below its 200 day moving average---not a technical plus) and in a short term downtrend.  Its pin action suggests that it will challenge the lower boundary of its intermediate term trading range (roughly 10 points lower).
           
            Bottom line:  on the one hand, having traded into overbought territory, it isn’t unusual that the Averages would selloff.  On the other hand, the bulk of an upbeat second quarter earnings season is behind us, second quarter GDP printed with a four handle and Trump is taking (the first of many I assume) a victory lap on the US/EU trade cease fire; so I would think that investors could muster a bit more enthusiasm.  Granted the FANG stocks had a rough reporting season and that almost certainly had a dampening effect on sentiment. 

Based on the indices charts today, my assumption is that they go higher.  However, cutting the legs out from under the Market leaders gives me pause.  Follow through.

                UUP and GLD are definitely pointing to relative strong US economy.  The long Treasury seems to be trying but successfully challenging the lower boundary of its long term uptrend is needed to confirm that scenario.

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.  Despite the well anticipated second quarter GDP read, overall this week’s data was negative; in fact very negative given that three primary indicators disappointed.  My conclusion is that the economy simply isn’t growing as rapidly as many think; and to the extent that second quarter growth was an improvement over the first, there is certainly no evidence of sustainability. 

On the other hand, I have never thought that the economy was going into a recession.  And while there clearly is some probability of a meaningful pick up in the long term secular growth rate of the economy [deregulation, trade], I am not going to change a forecast based on the dataflow to date.

Also, lest we forget, the economic growth rate in rest of the global is starting to slow; and that can’t be good for our own prospects.  It is certainly possible, even probable, that the US can continue to growth in this environment.  But it is not likely that its growth rate is accelerating.  

My thesis remains that the financing burden now posed by the massive [and growing] US deficit and debt has and will continue to constrain economic as well as profitability growth.

In short, the economy is not a negative but it not a positive at current valuation levels.

(2)   the success of current trade negotiations.  If Trump is able to create a fairer political/trade regime, it would almost certainly be a plus for secular earnings growth. This week’s cease fire with the EU brings hope that this will be the case.  Although I have documented plenty of naysayers to that proposition.  Unfortunately, if the Donald fails, the reverse is also true,

(3)   the rate at which the global central banks unwind QE.  That remains a somewhat  muddled picture this week as:

[a] the Bank of China continues to expand its money supply as part of an attempt to offset the hurt being laid on it by the Trump tariffs,

[b] it is increasingly obvious, even to the Japanese, that their version of QEInfinity has been a failure.  The BOJ meets next week and rumors are that it wants to take its first tightening step.  Unfortunately, the Japanese bond market is having a hissy fit.  So this week the BOJ has been trying weasel bond investors into believing that tightening really won’t have the consequences that it almost surely will.  Stay tuned on how it manages this situation,

[c] the ECB met this week and confirmed that it will begin drawing down it balance sheet in December,

[d] the Fed has already confirmed its policy of raising rates and unwinding its balance sheet. (must read)

Thus, the global economy is now experiencing dueling QE policies among the largest central banks on the planet. In that environment, I have little confidence is projecting a path for global QE going forward; but I remain convinced that it has done and will continue to do harm to the global economy in terms of the mispricing and misallocation of assets, that sooner or later that mispricing will be reversed and, given the fact that the Markets were the prime beneficiaries of QE, they will be the ones that take the pain of its demise. 

(4)   finally, valuations themselves are at record highs based on an economic/corporate profit scenario that I consider wishful thinking.  Even if I am wrong, there is no room in those valuations for an adverse outcome which we will inevitably get.

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.

                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 7/31/18                                  13643            1682
Close this week                                               25451            2818

* 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.