Saturday, December 1, 2018

The Closing Bell


The Closing Bell

12/1/18


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                     13824-30031
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range                          2705-3476
                                    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 a neutral for equity valuations.   The data flow this week was quite negative: above estimates: weekly mortgage and purchase applications, October personal income and spending, month to date retail chain store sales, the November Chicago PMI; below estimates: October new home sales, October pending home sales, weekly jobless claims, November consumer confidence, the November Dallas and Richmond Fed manufacturing indices, second estimate of Q3 corporate profits, the October trade deficit; in line with estimates: the September Case Shiller home price index, the October/revised September Chicago Fed national activity index, second estimate of Q3 GDP.

However, the primary indicators slightly positive: October personal income (+), October personal spending (+), Q3 GDP (0) and October new home sales (-).  I am giving this week a neutral rating.  Score: in the last 164 weeks, fifty-three were positive, seventy-three negative and thirty-eight neutral.

The data from overseas was not that great.  Plus, the ongoing turmoil over Brexit, the Chinese/US trade relations and Italy’s budget dispute with the EU potentially detract from global economic growth and, hence, US growth.
               
My forecast:

A number of Trump policy changes should have a positive impact on what is now a below average long term secular economic growth rate.  These include 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, the explosion in deficit spending, especially at a time when the government should be running a surplus, is a secular negative.  My thesis on this issue is that at the current high level of national debt, the cost of servicing the debt more than offsets (1) any stimulative benefit of tax cuts and (2) the secular positives of less government regulation and fairer trade [at least on the agreements that have been renegotiated].

On a cyclical basis, while the second quarter numbers were definitely better than the first, third quarter stats showed slower growth and current expectations for the fourth quarter are even lower.  Perhaps more concerning is the forward sales/earnings guidance from leaders in major sectors of the economy suggesting a further slowdown in growth that is more pronounced than current consensus.

So my current assumption remains intact---an economy growing slowly though the risk of recession may be mitigated somewhat by a less hawkish Fed.

       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.

Troubles in the Chinese financial system.

Goldman joins Wells Fargo and Deutsche Bank as examples of how the financial system is not fixed (must read):

                  Speaking of Deutsche Bank.

(2)   fiscal/regulatory policy. 

Trade remains the most immediate issue; in particular, the negotiations between Trump and Xi this weekend.  You know my thesis on this matter: the US has allowed China to get away with egregious policies [theft of intellectual property] so that it could move into the twentieth century.  Those policies were [a] the right thing to do and [b] very successful.  But the more that they succeeded, the more disadvantageous the US economic position became.  So now the US is faced with enduring some short term pain to correct these inequities or take the long term pain of being China’s patsy.  My vote is the former, but, as I noted, I don’t think that it can’t be achieved without negative consequences.

Another issue is the funding of the border wall.  While fiscal gridlock appears to the favored scenario for the next two years, funding for the wall will be a problem in this lame duck session.  Trump wants it; the dems don’t.  With a partial government funding deadline rapidly approaching [12/7], the Donald is threatening to shut down the government if the dems don’t relent.  We’ll see; historically, that is not a winning strategy.  We have that to look forward to next week.

Two minor notes: [a[ the US, Canada and Mexico signed the NAFTA 2.0 agreement, though congress still has to ratify it and [b] the house suspended the vote on a new tax bill.


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 major central bank/monetary policy headline this week was a speech by Powell [Wednesday] in which he seemed to completely reversed his prior hawkish position on QT. This more dovish stance on policy was supported by the narrative in the minutes of the last FOMC meeting released on Thursday. I say ‘seemed’ because while he implied fewer rate hikes were forthcoming, he left the matter of the unwind of the Fed’s balance in question.  I covered this in Thursday’s Morning Call; but to summarize my conclusion:

[a] slowing the increase in interest rates may help the economy a bit; but I was never really worried about it in the first place.  To be sure, that may act as a decelerant to any slowdown in economic growth; but I don’t think it critical to my forecast for the economy, short or long term,

[b] what is important, in my opinion, is the unwind of the Fed’s balance sheet, i.e. the removal of the QE excess liquidity and the reversal of the mispricing and misallocation of assets {price/risk discovery}.  At the moment, we don’t know what policy will be on this issue.  But if it continues my bottom line remains the same: the unwinding of QE will have little effect on the US economy but will reverse the gross mispricing and misallocation of assets.

A trade war is not a reason to ease money:

The corporate debt party is getting out of hand.

(4)   geopolitical risks: 

Brexit, the EU/Italy standoff; and now Russia and Ukraine are threatening each other.  They all could be much to do about nothing; or any one could cause serious negative financial consequences. I have no clue on any potential outcome; but they can’t be ignored.

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

[a] October EU unemployment was higher than expected; October German retail sales were lower; and the November EU economic confidence was above estimates,

[b] November Chinese composite, manufacturing and nonmanufacturing PMI’s were all below forecasts,

[c] October Japanese retail sales and November industrial production were well above expectations while November CPI was well below.

            Bottom line:  on a secular basis, the US economy 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.

            However, these potential long term positives are being offset by a totally irresponsible fiscal policy.  To be sure, the Trump mandated spending cuts would be a great start to correcting this problem.  Further, political gridlock could shut down any new tax cut/spending increase measures.  For that, we should all be thankful.  But until evidence proves otherwise, my thesis is 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 derived from deregulation or the current somewhat improved trade regime.

Cyclically, growth in the second quarter sped up, helped along by the tax cuts.  Plus (1) removing the uncertainty of no NAFTA treaty should help return economic conditions within the three countries to what they were before and (2) a slowdown in the rise of short term interest rates will likely improve economic sentiment.  On the other hand, trade fears [China] and a weakening global economy point to slower growth if not outright recession.  As I noted above, that is not my forecast at the moment.

The Market-Disciplined Investing
           
  Technical

The Averages (DJIA 25538, S&P 2760) had another good day and are starting to work through some of the technical damage to their charts: (1) the Dow traded above its 200 DMA for the third day [now resistance, if it remains there through the close Monday, it revert to support, (2) the S&P traded above the upper boundary of the developing very short term downtrend [if it closes there on Monday, the trend will be voided].  Two other factors that should have a positive impact on the pin action:  (1) we are in a historically strong seasonal period for stock prices and (2) both indices have made a higher low off the late October low.

That said, the S&P remains below its 200 DMA (just barely).  As you know, I think that this most important current resistance level for both indices.

The VIX was down 3%.  Its chart remains positive (bad for stocks): above both MA’s and within a short term uptrend. It is amazing to me that the VIX held up so well in a week in which the Dow was up 1300 points. 

The long bond rose 3/8 %.  While it continues to build a base very short term, it still finished below both moving averages and in a short term downtrend; meaning that until some of these resistance levels are successfully challenged, the assumption is that bond prices are going lower.

The dollar was up 3/8%, finishing in very short term and short term uptrends as well as above both MA’s.  In short, the chart remains technically strong.  I continue to believe that UUP will move higher as long as the dollar funding problem persists. 

GLD traded down but remained above its 100 DMA and continues to build a base. Its chart is getting less negative.

 Bottom line: investors remain jiggy, I assume over the prospects of a more dovish Fed and a China/Xi trade deal.  As you know (1) I have reservations about the Fed’s move being that positive and (2) I have no idea how to be optimistic about anything coming out of the China trade talks other than smoke and bulls**t.  I take some solace that investors in the VIX, the dollar, bonds and gold seem to agree with me.  But as I noted yesterday, I am clearly subject to being wrong on both counts.  If I am wrong, then prices are going higher.

            Latest on margin debt.

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.  Economic activity in the third quarter slowed and everyone pretty much agrees that it will do so again in the fourth quarter.  This is all borne out in the dataflow.

Also, lest we forget, the growth rate in rest of the global economy has slowed and appears to be slowing even further as fears of a prolonged US/China trade war impact corporate investment/spending plans. 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 the rate of growth will likely be declining nonetheless.

My thesis is that, a trade war aside, the financing burden now posed by the massive [and growing] US deficit and debt is offsetting the positive effects of deregulation and fairer trade and will continue to constrain economic as well as profitability growth.

In short, the economy is not a negative [yet] but it is 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 largely reshuffled the deck chairs and 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. 

(3)   the rate at which the global central banks unwind QE.  The Fed appears to be pulling back from its move to hike the Fed Funds rate.  However, that is less important to QT than the run off of its balance sheet---and, at the moment, we don’t know what is happening on that issue.   In addition, the ECB appears on schedule to halt its bond purchase program.

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 negative effects of the trade dispute with the US.  I have no clue how this dance of conflicting monetary policy will play.

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.

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. 

Whether or not I am right about overall valuation levels, investors seem to be balking at raising valuations any further. That doesn’t mean that a crash is imminent but it does suggest that, at a minimum, further upward progress may be limited.

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.  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 12/31/18                                13860            1711
Close this week                                               25538            2760

* 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.