Saturday, September 8, 2018

The Closing Bell


The Closing Bell

9/8/18


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                     13604-29809
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2627-3398
                                    Intermediate Term Uptrend                         1308-3122                                                          Long Term Uptrend                                     905-3065
                                                           
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 purchase applications, month to date retail chain store sales, weekly jobless claims, August manufacturing PMI, August ISM manufacturing and nonmanufacturing indices, the July trade deficit; below estimates: weekly mortgage applications, the August ADP private payroll report, July construction spending, August services PMI, July factory orders, revised Q2 productivity; in line with estimates: revised Q2 unit labor costs, July/August nonfarm payroll and the unemployment rate.

Primary indicator were largely negative: July construction spending (-), July factory orders (-), revised second quarter productivity (-) and July/August nonfarm payrolls (0).  So I rate this week a negative.   Score: in the last 152 weeks, fifty-one were positive, seventy-one negative and thirty mixed.

            One note on Friday’s employment report.  While the talking heads were mostly upbeat about the number, I thought it mixed at best: (1) the July reading was revised down by more than the August stat beat expectations, (2) the average increase in employment over the last three months has been less than needed to absorb the natural growth of the labor force---hardly a robust datapoint.  Clearly, I am less jiggy than the chattering class.

             And:

The numbers from overseas this week were mixed, continuing the trend of mixed to negative stats.  That means our own economy is losing 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; and there has been positive developments on that score with the new US/Mexico trade agreement.  Unfortunately, if negotiations with Canada, the EU, China and now Japan aren’t fruitful, 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 again, there was some upbeat news on this front with the proposed freezing of federal employee salaries and improvements in the budgeting process.

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.  

                        Update on the big our economic indicators (medium):

       The negatives:

(1)   a vulnerable global banking system.  

The overseas dollar funding problems [the necessity to buy dollars to service/refinance current dollar denominated debt] continue to grow as more countries are having problems.  This issue impacts the banks because they own a major portion of the debt that is being serviced/refinanced.  If that debt goes into default, then the banks’ balance sheets/capital account takes a direct hit and that would in turn [a] impede lending and [b] weaken their solvency, making their own debt more difficult to service/refinance. 

Not helping matters, S&P decided to revise its rating system for Chinese credits, basically giving the same rating to an entity as the Chinese government gives it---irrespective of balance sheet strength, level of profitability, etc.  In short, mask the true creditworthiness of the entity [remember the rating services’ error with mortgage backed securities].

The global economy has had crises brought on by dollar funding problems twice in the last thirty years.  The results were not pretty.  To date, we are not in as extreme a circumstance; but we are clearly moving in that direction.

(2)   fiscal/regulatory policy. 

This week, politics dominated the headlines until Friday.  Lost in the shuffle were:

[a] Trump’s action to freeze federal employee pay,

[b] the congressional GOP proposals to improve the budgeting process {separate votes on each portion of the budget},

[c] additional details on the new improved second tax bill: {i} make the individual tax cuts permanent---while this won’t undo the damage done to the deficit/debt by the first tax bill, at least, it won’t make it worse, and {ii} ease rules on retirement savings---that is a potential plus for the deficit/debt in that if retirement savings can be increased, it could allow some room to the rein back/slow the grow of social security benefits.

While I do not believe these measures are sufficient to offset the enormous and growing  deficit/debt problem, they, at least, don’t make it worse.

But on Friday, trade again became the lead story as [a] Trump didn’t impose the $200 billion in tariffs on China that he has threatened, but [b] upped the ante by saying that he would impose additional $267 billion in tariffs {$467 billion in total}.  For some reason, investors ignored Trump’s initial inaction---which I interpreted as meaning progress was being made in US/Chinese trade talks---but zeroed in on the second---which I also interpreted as a not so subtle message to the Chinese not to be wasting our time.  In short, I thought this all good news.  Mr. Market disagreed.

(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 misallocation of assets problem is now showing up as an emerging market dollar funding problem.  As a brief review, this problem has arisen because when the Fed was pursuing QEInfinity, there were lots of dollars that could be borrowed cheaply by less creditworthy entities [like emerging market countries].  Now that the Fed is tightening, there are fewer dollars available to service/refinance those loans.  That drives up the price of dollars, making it even more difficult/costly to service/refinance those loans [this is a prime example of the misallocation of assets].  The longer this circumstance persists, the more likely that one or more countries default on a loan, which, as I noted above, then echoes through the global banking system.  At that point, things get serious.

And:

NY Fed head says that he is not worried about inverting the yield curve.  Bear in mind, this guy has been a leading dove.  Also bear in mind that ‘this time is never different’, i.e. the Fed has never, ever in its history successfully managed a transition from easy to tight money.

As you know, I believe that ending QE will have little impact on the US economy but cause pain for the Markets whenever and however it unwinds.    

The math of quantitative tightening (QT) (medium):

The yield curve and bank profitability (medium and a must read):

(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]. 

Viewed through that prism, we got some good news as [a] nothing appears to have come up about ‘the Wall’ or US immigration policy in the US/Mexico trade talks/agreement and [b] North Korea and the US exchanged vows of love this week in spite of the looming imposition of additional tariffs on Chinese goods.


(5)   economic difficulties around the globe.  Another week of sub-par results:

[a] August EU manufacturing and services PMI’s and Q3 GDP were all in line; July German factory orders fell dramatically for the second month in a row,

[b] August Chinese Caixin services PMI was below estimates.

            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 though clearly the US/Mexico agreement is a positive step.

At the same time, these long term positives are being offset by a totally irresponsible fiscal policy though I do have to take the proposed second tax cut bill off the list of egregious measures.  The original tax cut, increased deficit spending, a potentially big infrastructure bill and funding the bureaucracy of a new arm of military (space force) will negatively impact economic growth and inflation, in my opinion.  Until evidence proves otherwise, my thesis remains that cost of servicing the current level of the national debt and budget deficit is 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 25916, S&P 2871) were down on Friday.  Volume rose.  Breadth was weak.  However, the Averages remain strong technically; and my assumption is that they will challenge the upper boundaries of their long term uptrends (29807, 3065).

The VIX was up again, closing above its 100 DMA for a third day, reverting to support and above its 200 DMA (now resistance; if it remains there through the close on Wednesday, it will revert to support)---if it successfully challenges this level, we have to entertain the idea that stocks may be going lower. 

TLT got pounded, closing (1) below its 100 DMA [now support; if it remains there through the close next Tuesday, it will revert to resistance], (2) below its 200 DMA [now support; if it remains there through the close on Wednesday, it will revert to resistance], [3] the lower boundary of its long term uptrend [if it remains there through the close on Thursday, the trend will reset to a trading range] and broke out of the long pennant formation.  Remember though that TLT has briefly pushed below the lower boundary of its long term uptrend four times in the last year; so we need some follow through to the downside before assuming that prices are headed much lower.

The dollar rose, and remains technically strong.  That is not likely to change as long as dollar funding problems continue in the emerging markets.
                       
           GLD was down and continues to have the ugliest chart on the block.
               
          Bottom line:  despite a schizophrenic week in stock trading, the indices remain strong and I continue to believe that they will challenge the upper boundaries of their long term uptrends.  The dollar will likely remain strong until the dollar funding problems are resolved.  The bond crowd may be changing their long term perspective.  The successful challenge of TLT’s long term uptrend will be significant, technically speaking.  And if it occurs, that will likely provide additional strength to the dollar and weakness in GLD.
                         
            Friday in the charts.

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.  Taking the second quarter GDP number by itself, it would be easy enough to project increasing growth, mom’s apple pie, free love and nickel beer into the future.  But I can’t do that.  The tax cuts almost assuredly had a significant effect on Q2 growth.  But:

[a] that was a one-time shot in the arm.  Unless it alters investing and consumption behavior on a more permanent basis, it is meaningless in terms of future growth, 

[b] and so far, the data don’t support the thesis that the economy is experiencing any kind of lift off.  Indeed, third quarter results so far indicate softening back toward the former modest rate of growth.

My conclusion remains that while the economy is growing, it simply isn’t growing as rapidly as many think.  On the other hand, as you know, 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 if the rest of the world slows.  But it is not likely that its growth rate will accelerate.  

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.  Clearly, the US/Mexico agreement is a step in that direction.  However, Canada appears to be resisting joining the pact [though I believe that it ultimately will], the Donald has spurned advances by the EU, seems intent on hammering China again and added Japan to the list of countries that he wants to revise trade agreements. I remain hopeful that his 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.  At present, it is happening.  Given the recent comments from various Fed members, it seems likely to continue at least in the US.  Further, the bond boys look like they are becoming convinced that rates are going up---though that is not a certainty at the moment.  I have little confidence is projecting a path for rest of the global central banks; but I remain convinced that [a] QE 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/misallocation will be reversed---and the dollar funding problem is the first material sign that it is happening 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 9/30/18                                  13764            1698
Close this week                                               25916            2871

* 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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