The Closing Bell
10/13/18
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 13678-29883
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2665-3436
Intermediate
Term Uptrend 1315-3130 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: month to date retail chain
store sales, August wholesale inventories/sales, September CPI; below
estimates: weekly mortgage and purchase applications, weekly jobless claims,
preliminary October consumer sentiment; in line with estimates: the September
small business optimism index, September PPI, September import/export prices.
No primary
indicators this week. Since the dataflow
this week was not only paltry but also mixed, I am giving a weak neutral rating. Score: in the last 157 weeks, fifty-two were
positive, seventy-one negative and thirty-four neutral.
Nonetheless, several
comments:
(1)
the PPI, CPI and export prices stats showed inflation
still well under control which gives the Fed the excuse, if it chooses to use
it, to ease up on its current tightening policy. But I want to offer my opinion on a couple of
things. I keep hearing from the media
that the Fed is tightening money because it fears inflation. There isn’t any inflation. Look at the
aforementioned numbers. The Fed is
tightening money because it is attempting to unwind its ginormous balance sheet
which has created multiple distortions in the economy, not the least of which
is the mispricing and misallocation of assets.
I also hear that long rates are rising because the Fed is raising the
Fed Funds rate. While that may play a
partial role, long rates are rising because liquidity problems in the global
financial system [dollar funding problems],
(2)
the IMF cut its 2018 global and US economic growth
forecasts, supporting my outlook for a re-slowing of growth following the tax
induced pop in the second quarter numbers,
(3)
third quarter earnings season started this week and
that should give us another take on the strength of the economy.
Our forecast:
A pick up in what
is now a below average long term secular economic growth rate based on less
government regulation with some minor help from the recent agreements with
Mexico/Canada/South Korea. There is the potential that Trump’s trade
negotiations with Japan, the EU and China could also lead to a further
improvement in our long term secular growth rate. However, much more needs to be done for this
factor to be a significant positive.
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).
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 growing slowly but not accelerating.
The
negatives:
(1)
a vulnerable global banking [financial] system.
I re-introduced this subject a couple of weeks ago,
altering it slightly to incorporate the entire financial system, specifically
the shadow banking system [nonbank loans from hedge funds, finance companies,
etc.]. The reason being [a] the
tremendous growth in this segment of the financial market [b] the weak credit
standards currently demanded by the lending institutions, i.e. a lot of
nonrecourse and covenant lite loans, and [c] the use of derivatives by the
lenders to hedge their bets. Recall that
this was one of the main problems in the 2008/2009 crisis. I am not suggesting that conditions can
deteriorate as significantly as they did back then. But they don’t have to in order to result in
liquidity/solvency problems.
(2)
fiscal/regulatory policy.
The principal
headline this week was the announcement that Trump and Chinese Premier Xi would
meet during the upcoming G20 meeting.
Even though I believe that the Donald is following the right strategy in
confronting China regarding its theft of intellectual property, I don’t believe
that anything material is going to happen before the November elections. Indeed, I suspect that China has evaluated
the NAFTA 2.0 deal, seen that changes from the original deal were minor and
may, therefore, offer some inconsequential fig leaf that Trump would grasp in
order to declare victory.
If so, it
would add to my disappointment that the NAFTA 2.0 deal wasn’t a better one for
the US. To be clear, it was a net
positive; but it was not in the spirit of what I thought was Trump’s goal to re-set
the post WWII political/trade regime.
That said,
like NAFTA 2.0, even a marginally better trade deal would remove the negative
that a slowdown in trade based just on the uncertainty of the situation would
have on the US economy. So on a cyclical
basis, it would be a plus. However, long
term, slightly better trade deals are not going to have that large an impact on
the secular growth of the economy and that is potentially a factor that I have
hoped would help the US economy regain its former secular growth rate.
Unfortunately, the real turd in the fiscal policy punchbowl
is the growing budget deficit/national debt at the same time the economy is
doing well. That is exactly opposite of
how fiscal policy is supposed to work, i.e. deficits during recessions,
surpluses during booms. And I don’t
think this situation is going to get any better---plans abound for additional
tax cuts and more spending.
You know my bottom line: once the national debt reaches a
certain size in relation to GDP [and the US has already attained that dubious
honor] the cost of servicing that debt offsets any benefits to growth that
might come from tax cuts/infrastructure spending.
(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 asset bubbles in the stock market as well as
in the auto, student and mortgage loan markets.
The most
important question on this point is, does Powell really mean that the Fed will
continue to tighten money, irrespective of its impact on the Market? As you know, my opinion since the inception
of QEII was that it was a major mistake for the [Bernanke/Yellen] Fed to add
the stabilization of financial markets as a third objective to its
congressionally mandated goals of containing inflation and unemployment. It destroyed price [risk] discovery and led
to the gross mispricing and misallocation of assets. If that regime is over then sooner or later
price discovery will return.
The
Fed is undergoing a change in attitude.
Another consequence of a tightening monetary policy is the pressure is
puts on weak foreign issuers of dollar denominated debt. We are already seeing funding problems not
only in emerging markets like Argentina, Turkey, Pakistan, India and the Philippines
but also larger economies like China and the EU.
You know my bottom line: the unwinding of QE will have little effect on
the US economy but will reverse the gross mispricing and misallocation of
assets.
When
the next recession hits.
(4) geopolitical
risks: the denuclearization of North
Korea seems to be moving forward [‘seems’ being the operative word] though
Syria remains a flash point, as well as the current instability related to Brexit
and Italy’s fight with the ECB. All
risks; none on the front burner.
Though Italy
may soon be.
(5)
economic difficulties around the globe. The stats this week were negative:
[a] September EU manufacturing PMI was slightly below
forecasts,
[b] the September Chinese trade surplus
with the US hit a record $34.1 billion.
Bottom
line: on a secular basis, the US is
growing at an historically below average secular rate although I assume decreased
regulation and the likely successful completion of the NAFTA 2.0 agreement will
improve that rate somewhat. Certainly,
removing the uncertainty of no NAFTA treaty should help return economic
conditions to what they were before. The
same is equally true if Trump is successful in revising the trade agreements
with the EU, Japan and China. ‘If’ being
the operative word, especially as it applies to China where it looks like the
current standoff will prove protracted.
At the same
time, these long term positives are being offset by a totally irresponsible
fiscal policy. The original tax cut, increased
deficit spending, a potentially big infrastructure bill and funding the
bureaucracy of a new arm of the military (space force) will push the
deficit/debt higher, negatively impacting economic growth, 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
We finally got
the oversold rally on Friday with the Averages (DJIA 25339, S&P 2767)
closing nicely higher. However, in the
preceding decline, the S&P voided its very short term uptrend, reverted its
100 DMA from support to resistance and is on the cusp of doing the same with
its 200 DMA. It did manage to close
right on the boundary which simply extends the clock by a day; in other words,
it now has to remain below this MA until Wednesday to confirm the break. Of course, any close above it would negate
the break.
The Dow did a
bit better, finishing back above its 200 DMA voiding that break but remained below
its 100 DMA (now support, if it remains there through the close on Monday, it
will revert to resistance). The latter
is a mildly hopeful sign that the S&P could follow suit.
Volume declined
and breadth recovered though only slightly.
The VIX fell 14
½ %, but remained above its 100 DMA (now support) and its 200 DMA (now support)
and the upper boundary of its short term trading range, resetting to a short
term uptrend. A negative for
stocks.
The long bond resumed
its decline after a huge spike on Thursday.
Despite the pop, TLT remained in an intermediate term downtrend (it
failed to even recover the lower boundary of its former intermediate term
trading range), a long term trading range and below both MA’s. Still a negative technical picture.
The dollar was up
fractionally, retaining its positive technical standing. Though failing to challenge its August high
is a bit of a negative. However, I
continue to believe that UUP will move higher as long as the dollar funding
problem persists.
GLD sold off ½ %
following Thursday’s major jump on massive volume. However, it remained above the upper boundary
of its short term downtrend (if it remains there through the close on Monday,
it will reset to a trading range). This
is the first positive technical development for gold in a long, long time. Follow through.
Bottom line: Friday’s rally off an
extremely oversold condition was to be expected. For it to be anything more, the S&P needs
to end above its 200 DMA and the Dow to hold above its 200 DMA on Monday. (Remember,
those 200 DMA’s have represented major support on multiple occasions for almost
two years.) As always, follow through
from critical technical levels is most important. Patience.
To repeat, my
Friday observation: Taking a step back, it is important to view (Wednesday and Thursday’s
pin action) with some perspective---that
is, that (the Averages) are barely
off their all-time highs. So it is no
time to get beared up. Even though I
have thought that stocks were overvalued for over the last two years and that a
selloff was due, it doesn’t mean that mean reversion has started. On the other hand, every journey starts with
a single step.
Bonds, the dollar and gold continue
to trade at odds with each other, though I think that the ‘safety trade’
element got mixed into the fundamental considerations on Wednesday and
Thursday.
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), the
improved regulatory environment notwithstanding. At the moment, the important factors bearing
on Fair Value (corporate profitability and the rate at which it is discounted)
are:
(1)
the extent to which the economy is growing. Clearly, the second quarter GDP number propelled
by the tax cuts was a sign of improved growth.
Nevertheless, that is a single stat and in no way implies a trend. Indeed, [a] most Street estimates for third
quarter GDP growth are lower than that of Q2, [b] the Fed’s forecast for longer
term growth shows a gradual decline back toward what has been a below average
secular growth rate and [c] the forward {sales and earnings} guidance from many
companies has begun to decline {autos, construction, airlines, packaging}.
Unless
those tax cuts alter investing and consumption behavior on a more permanent
basis, Q2 growth will likely prove to be the peak growth rate of this economic
cycle. Furthermore, the effect that
those tax cuts are, at least presently, having on the deficit/debt are just as
meaningful, in my opinion, as any growth implications, to wit, financing the
deficit and servicing of debt will constrain growth.
My
conclusion remains that while the economy has experienced a pop in its cyclical
growth resulting from the tax cuts, it simply can’t and won’t sustain that
growth rate on a secular basis and will gradually revert back to the pre-tax
cut, below average (less than ~2%) rate.
To be clear, I am not saying that the economy is going into a recession. And while there clearly is some probability
of a pickup in the long term secular growth rate of the economy [deregulation,
trade], I am not going to change a forecast, beyond what I have already done, based
on the dataflow to date or the promise of some grand reorientation of trade.
Also,
lest we forget, the growth rate in rest of the global economy has slowed and
will not be helped by the decelerating effects of the dollar funding problems
in the emerging market. That can’t be
good for our own prospects. It is
certainly possible, even probable, that the US can continue to grow as the rest
of the world slows. But it is not likely
that its second quarter growth rate will be maintained.
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/Canada and South Korean
agreements are a step in that direction.
But there is general agreement [except within the Administration] that
these revised treaties will barely move the needle on the secular growth rate
of the economy; though certainly there be a cyclical effect from the removal of
uncertainty.
However,
the US remains at loggerheads with China.
Plus Trump is insisting on a changes in the terms of our trade
agreements with Japan and Europe. So
there is much to be done before altering any assumptions about an improvement
in economic growth.
Nonetheless,
my bottom line is that I, perhaps foolishly, remain optimistic that the
Donald’s current negotiating strategy will pay off; hopefully with better
results than NAFTA 2.0. 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. The Fed continues to raise rates, its forward
guidance is to expect more hikes and a continuation of the run off of its
balance sheet. Perhaps most telling is the comments from various FOMC members
that the Fed is no longer reacting with any sensitivity to the
Markets---assuming they really mean it. I
have opined that this would drive the after effects of QE, i.e. the return to
price discovery and the correction of the mispricing and misallocation of
assets. And, the Market aside, we are
starting to see those after effects in the dollar funding problems in foreign
economies.
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 [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, notwithstanding two rough trading days this
week, valuations remain at record highs [at least as calculated by my Valuation
Model] based on the current generally accepted 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.
However,
I would reemphasize a point that I made early in the week: we have witnessed air pockets in stock prices
many times in this current bull market that soon recovered because [a] the
economy was slowly albeit sluggishly improving and [b] the Fed had its foot on
the accelerator.
Now [a] interest rates are up, [b] the Fed
continues to shrink money supply and that is causing dollar funding indigestion
not only in the emerging market but also seems to spreading to the developed
markets; as important, Powell has made clear that he expects to continue to
tighten whatever happens to the Markets---a massive change in attitude from the
Bernanke/Yellen regimes, [c] corporations have record levels of debt,
especially in the lower rated credit segment and [d] are starting to lower
profit expectations, [e] finally…..the bugaboo from the last financial crisis,
i.e. derivatives, has reappeared with all its associated counterparty risks.
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 10/31/18 13796
1702
Close this week 25339
2767
* 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
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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