Saturday, August 11, 2018

The Closing Bell


The Closing Bell

8/11/18


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                                     2597-3368
                                    Intermediate Term Uptrend                         1298-3112                                                          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: June month to date retail chain store sales, weekly jobless claims, July PPI; below estimates: weekly mortgage/purchase applications, consumer credit, June wholesale inventories/sales; in line with estimates: July CPI.

No primary indicators.  So I rate this week a neutral. Score: in the last 148 weeks, fifty were positive, sixty-nine negative and twenty-nine neutral.  In short, nothing here to give a reason for a change in our outlook.

I still want to comment on a couple of numbers:

(1)   the June wholesale/sales figure was hardly a sign of an accelerating economy,

(2)   since the Fed is zeroed in on inflation, the CPI/PPI bear mention.  On the one hand, the month over month PPI suggests a stable economy and, hence, might provide an excuse for the Fed to pursue a ‘go slow’ approach to tightening.  However, the year over year stats for both indices registered a more rapid advance of inflation.  Indeed, the CPI was at the high end of the Fed’s acceptable range.  That will likely keep it on its current path of unwinding QE and could even hasten the return to normality.  If so, the point where the unwind of QE starts to cause Market pain draws closer [at least in my opinion].

The numbers from overseas this week were again disappointing.  So 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.

Our (new and improved) forecast:

A pick up in the long term secular economic growth rate based on less government regulation. 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.  

On Friday, I noted that the Turkey had joined the crowd that are having currency [dollar funding] problems.  The importance of this is that much of Turkey’s debts are dollar denominated and owed to banks in other countries.  If Turkey’s lira is plunging in value versus the dollar, that means that servicing that dollar denominated debt is getting very expensive---the risk being, that it becomes prohibitively so. 

One man’s thoughts (medium):

Sheila Bair on the US banking system (medium and a must read):

(2)   fiscal/regulatory policy. 

This week, trade stayed in the news but not in the three inch headline sense.  US and China swapped threats to raise tariffs on August 23---something we basically already knew.

As you know, I believe that [a] the Donald is right in attempting to reset the post WWII political/trading regime, but that said [b] the outcome of current  negotiations are an important variable in our long term secular economic growth rate forecast. 

At the moment, the only thing that has changed is the increase in tariffs, which is definitely not good for the global economy.  The hope, of course, is that his strategy will produce a fairer deal for the US.  However, 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.

The other item was the Pence announcement of a proposal for a ‘space force’.  I covered this in Friday’s Morning Call, so I won’t be repetitive except to say that it will only contribute a huge existing 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. 

                  The rising interest payments on US government debt (medium and a must read):

(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.  

Another must read from Jeffery Snider (medium):

All quiet on the central bank front.

In my opinion, ending QE will cause little economic impact but major pain for the Markets whenever and however it unwinds.    

(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.  Another week of sub-par results:

[a] June German factory orders fell dramatically, industrial production was down more than anticipated and its trade balance declined,

[b] the July Chinese exports and imports were both above forecasts as were July PPI and CPI.

[c] June Japanese machine orders fell 8.8% versus projections of -1.0%; but second quarter GDP was better than expectations.

            Bottom line:  on a secular basis, the US long term economic growth rate could improve based on decreasing regulation.  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.

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, a potentially big infrastructure bill and funding the bureaucracy of a new arm of military will negatively impact economic growth and inflation, in my opinion.  Until 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 25313, S&P 2833) had a rough day on increased volume and deteriorating breadth.  However, they remain strong technically.  Plus Friday’s pin action was a gap down; and, historically, gaps get closed (i.e. the price trades up to close the gap between the high for the day with the low of the prior day).  On the other hand, if the Averages continue to decline, the Dow’s 100 DMA will likely fall below its 200 DMA---and that is not a positive signal.  In addition, the VIX bounced dramatically back above the lower boundary of its short term trading range---suggesting that any advance in stock prices may be labored.

TLT’s battle with its long term uptrend’s lower boundary got interrupted on Friday by the mounting Turkish currency crisis (and its potential impact on the EU banking system).  Suddenly, it spiked as a result of its role as a safety trade which superseded any debate over US economic strength and Fed policy.  Looking ahead, the question is, is the Turkish crisis a short term problem (and the Market’s focus will return to the earlier dispute over the long term direction of interest rates) or is it a sign of more dollar funding problems for the global banking system (in which case it will remain a safety trade)?  Stay tuned.


          The dollar spiked also reflecting its function as a safety trade.  GLD couldn’t manage an uptick even on a big risk off day.
           
            Bottom line: on Friday, every index was impacted by the situation in Turkey; and until, as and if that gets cleared up, their pin action may likely be more a function of international events versus anything going on in this country.  That said, it is way too soon to be drawing any long term conclusions.

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.  There was not enough in the numbers this week to provide much evidence of growth or not.    My conclusion remains 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 or the promise of some grand reorientation of trade.

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.  However, with vacations and some regional elections, there was not really any news on this front---though the US and China did both reiterate prior threats of increased tariffs  I remain hopeful that the Donald’s current negotiating strategy will pay off; however, the risks and rewards associated with failure and success are very high.  Either outcome would almost surely have an impact on corporate earnings and, probably, on stock prices,

(3)   the rate at which the global central banks unwind QE.  Very quiet this week.  However, the global economy is still facing a confusing and somewhat contradictory array of central bank monetary policy moves.  I have little confidence is projecting a path for global QE in that environment; but I remain convinced that [a] it has done and will continue to do harm to the global economy in terms of the mispricing and misallocation of assets, [b] sooner or later that mispricing will be reversed and [c] 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 the current economic/corporate profit scenario which includes an acceleration of economic growth [which I consider wishful thinking].  Even if I am wrong, there is no room in those valuations for an adverse development 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 8/31/18                                  13733            1694
Close this week                                               25313            2833

* 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.