Saturday, November 3, 2018

The Closing Bell


The Closing Bell

11/3/18


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                     13752-29957
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2689-3460
                                    Intermediate Term Uptrend                         1318-3133                                                          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 negative: above estimates: the October ADP private payroll report,  October nonfarm payrolls, month to date retail chain store sales, August/September construction spending, September factory orders, the October Dallas manufacturing index; below estimates: weekly mortgage and purchase applications, weekly jobless claims, September personal income, third quarter employment cost index, October Chicago PMI, the October Markit manufacturing PMI, the October ISM manufacturing index, third quarter productivity and unit labor costs, the September trade deficit; in line with estimates: the Case Shiller home price index, revised September/October consumer confidence, September personal spending.

However, the primary indicators were positive. October nonfarm payrolls (+), August/September construction spending (+), September factory orders (+), September personal income (-), September personal spending (0).  While I am a bit conflicted about a call, in the interest of not trying to talk my book, I am giving the week a positive rating.  Score: in the last 160 weeks, fifty-three were positive, seventy-two negative and thirty-five neutral.

Overseas, the economic data returned to negative. So the US economy is not being helped by any global growth.
       
There was very few economic/political developments that would impact my forecast.  The only one being the potential for meaningful trade talks between the US and China.  How much of this seeming change in attitude is purely political is as yet unknown.  Both sides need some short term relief, so cynicism shouldn’t be taken lightly.  The good news is that we won’t have to wait long to know the truth.

Our forecast:

A pick up in what is now a below average long term secular economic growth rate based on less government regulation with possible minor help from the recent agreements with Mexico/Canada/South Korea. There is the potential that (1) Trump’s trade negotiations with Japan, the EU and China and (2) possible spending cuts 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.

My fiscal thesis remains that at the current high level of national debt, the cost of servicing the debt more than offsets any stimulative benefit of tax cuts---subject to some revision if the spending cuts take place.

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.  

From last week:

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.

                 Where will the credit crunch pinch first (must read):

(2)   fiscal/regulatory policy. 

DC was on the campaign trail this week; so virtually no news other than ignorable promises and the potential easing of the trade standoff with China---which also has a decent probability of being ignorable.

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. (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  asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.  

The only central bank/monetary policy headline this week was the meeting of the Bank of Japan which left interest rates and QE unchanged---putting it clearly at odds with the Fed and the ECB.  The big question is, how will conflicting central bank monetary policies impact global liquidity?  Stay tuned because I have no clue.

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.

The ECB’s epic failure (must read):

(4)   geopolitical risks:  Brexit, Italy, Syria, Khashoggi: all simmering but nothing boiling over. 

(5)   economic difficulties around the globe.  The stats this week were negative:

[a] third quarter EU GDP was below estimates; September German retail sales were lousy, the October UK manufacturing PMI was below consensus,

[b] the October Chinese manufacturing and nonmanufacturing indices were less than anticipated; its October Caixin {small business} manufacturing PMI came slightly above forecast.

            Bottom line:  on a secular basis, the US is growing at an historically below average secular rate although I assume decreased regulation, the likely successful completion of the NAFTA 2.0 agreement and Trump’s spending cuts (assuming implementation) will improve that rate somewhat. 

Certainly on a cyclical basis, 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.

At the same time, these long term positives are being offset by a totally irresponsible fiscal policy.  To be sure, the aforementioned spending cuts would be a great start to correcting this problem.  But the recently announced middle class tax cuts as well as the out of control entitlement spending has to be addressed before the growing deficit/debt can be restrained.  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 25270, S&P 2723) took a rest on Friday.  However, the technical picture for both index didn’t change.  The Dow ended below its 100 DMA (now resistance) but above its 200 DMA for a second day (now resistance; if it remains there through the close next Tuesday, it will revert to support).

The S&P finished below both moving averages, above the upper boundary of its very short term downtrend, voiding that trend and above the lower boundary of its short term uptrend.

As positive as this all seems, the technical saw is that the indices still need to close Wednesday’s gap open.  Unfortunately, there is no time horizon on when the fill will take place.  So prices can go higher before closing the gap; but still assume that S&P ~2681/Dow ~24892 are going to be revisited in the not too distant future.

Volume rose, remaining elevated; breadth was mixed.

The VIX was up fractionally, finishing above both MA’s and in a short term uptrend.  However, the upper boundary of that trend acted as resistance and the VIX bounced off of it. 

The long bond was hammered, re-establishing a very short term downtrend and finishing within a short term downtrend and below both moving averages.   Still a negative technical picture, indicating higher interest rates.

The dollar was up, closing back above its August high, within a short term and a very short term uptrend and above both moving averages.  I continue to believe that UUP will move higher as long as the dollar funding problem persists. 

GLD lifted fractionally, ending above its 100 DMA.  However, there is nothing remotely decisive about its pin action.

 Bottom line: the Markets were really the story last week.  Equities sold off hard and then rallied equally so.  The implication of the latter (which was aided by favorable news [bulls**t?] on trade) is that the worse is over. 

On the other hand, TLT’s and UUP’s performances both continued to point to higher interest rates (a tighter Fed) which is definitely not a plus for the Markets. 

Right now, I am focusing on the S&P which is trading between its 200 DMA (which has been a significant level for the past two years) on the upside and the lower boundary of its short term uptrend (which it challenged unsuccessfully last week) on the downside.  Whichever of those boundaries gets successfully challenged should tell us a lot about (1) how much of the Donald’s trade comments that investors are willing to bet money on and (2) price direction.

            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 and the potential pluses from trade and spending cuts 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 potential sign of improved growth; and if this quarter’s earnings season continues to come in better than expected, it would indicate that, at least, some of the Q2 strength spilled over into the third quarter and would suggest the need for more optimism. Nevertheless, [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] to date, the overall trend in the dataflow does not support the notion that the economy continues to grow at the second quarter rate.

Many will point to the strong earnings third quarter reports as an indication of continued higher economic growth.  However [a] some of this improvement is the result of {i} advanced buying ahead of the imposition of Chinese tariffs and {ii} Wall Street’s inclination to focus on the generally more positive non-GAAP profits and [b] forward {sales and earnings} guidance from many companies has pointed to lower growth.   

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.  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 surely be a plus for secular earnings growth.  And while the US/Mexico/Canada and South Korean agreements help short term cyclical growth in that they remove uncertainty, 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.

A potential deal with China would be a huge plus if its theft of US intellectual property can be stopped; but any agreement that mimics the aforementioned NAFTA 2.0 agreement is not a template for success on that point.  One can only hope that there is more to this week’s announcement of progress in the US/China trade talks than just political smoke.  But a healthy dose of cynicism is probably appropriate.

Who to believe?

Or?

(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. And this week’s positive primary indicator readings will likely only serve to bolster the Fed’s conviction to continue its tightening strategy.

Perhaps most telling are the comments from various FOMC members that the Fed is no longer reacting with any sensitivity to the Markets---assuming they really mean it. 
The shrinking Fed balance sheet.

As you know, I applaud the end of QE because of its destructive impact on corporate and individuals’ investment decision making, i.e.  price discovery and the mispricing and misallocation of assets.  But it will have negative consequences for [a] credit borrowers---we are starting to see in the dollar funding problems in foreign economies and [b] financial markets, in general, as price discovery returns.

On top of that, the ECB will commence the unwinding of its own QE policy soon and that will only add to the global liquidity problem.  On the other hand, the BOJ remains entrenched in its version of QE and the Chinese are using every policy tool available, including monetary easing, to stem the effect of the trade dispute with the US.  As I noted above, I have no clue how this dance of conflicting monetary policy will play.

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 [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 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 any adverse development which we will inevitably get.

Finally [a] interest rates are up---raising the discount rate at which earnings and dividends are valued, [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 along with proposed spending cuts should have a positive impact on secular growth and, hence, equity valuations.  On the other hand, I believe that overall fiscal policy (growing deficits/debt) 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.

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 11/30/18                                13828            1706
Close this week                                               25270            2723

* 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.