Saturday, January 5, 2019

The Closing Bell


The Closing Bell

1/5/19


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%

            2019

Real Growth in Gross Domestic Product                          1.5-2.5%
                        Inflation                                                                          +1.5-2.5%
                        Corporate Profits                                                                5-6%


   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      21691-26646
Intermediate Term Uptrend                     13966-30174
Long Term Uptrend                                  6585-29947
                                               
2018     Year End Fair Value                                   13800-14000

                        2019     Year End Fair Value                                   14500-14700

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Downtrend                                2408-2642
                                    Intermediate Term Uptrend                         1338-3148                                                          Long Term Uptrend                                     913-3073
                                                           
2018 Year End Fair Value                                       1700-1720         
                        2019 Year End Fair Value                                     1790-1810

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                           56%
            High Yield Portfolio                                     55%
            Aggressive Growth Portfolio                        56%

Economics/Politics
           
The Trump economy is a neutral for equity valuations.   The data flow this week was mixed: above estimates: month to date retail chain store sales, the December ADP private payroll report, the December employment report, the December services PMI; below estimates: weekly mortgage and purchase applications, weekly jobless claims, the December ISM manufacturing index, December Dallas Fed manufacturing index; in line with estimates: the December manufacturing PMI.

Update on big four economic indicators.

There was only one primary indicator: the December jobs report (+).  Though like last week, another important stat wasn’t reported (November construction spending) due to the government shutdown.  Even though the construction number would likely have been negative, I am still going to give this week a tentative positive rating.  Score: in the last 169 weeks, fifty-five were positive, seventy-five negative and thirty-nine neutral.

The data from overseas was not good at all, much of the poor numbers being attributed to the US/China trade dispute.  Not helping is the ongoing turmoil over Brexit and the ECB taking administrative control of an Italian bank.

There were three big developments on Friday (at least in stock land).  First, the jobs report showed exceptionally strong employment growth.  The knee jerk reaction apparently was to think that all is well in the economy.  But it is not, and the numbers show it.  Remember that employment is a lagging indicator.  So, it is entirely possible to see good job growth as the economy loses steam.

Second, the US/China have agreed to vice-minister level trade talks beginning this coming Monday.  Certainly, getting back to the negotiating table is a plus.  But talking is not doing.  In my opinion, there is a long hard fight ahead of us before China gives up IP theft.  Assuredly, it needs to be done and when it is, hallelujah.  But there is much to trip between the cup and the lip.

Finally, Fed chair Powell made some dovish comments, the most important of which reversing his prior statement that QT was on autopilot to ‘Markets, we are listening to you’.  (Just to remind you, it is the Fed’s balance sheet unwind that is starting to cause liquidity problems in the Markets.) In short, he seems to have been reinstating the Greenspan/Bernanke/Yellen Fed ‘put’.  (Interestingly, he made those comments while sitting with both Bernanke and Yellen.)  Missed in what seems to have been a very favorable equity market response to the ‘listening’ statement, was any indication that QT was actually going to slow.  Indeed, Powell also said that ‘if’ the Fed thinks that there is a need to slow its tightening (normalization) process, it would act---with no suggestion that the ‘if’ circumstances were upon us.    

You know my sentiments on this issue.  Sensitivity to Market temperament is not part of the Fed mandate.  Nor should it be. I don’t think that it is clear that Powell is reestablishing the Fed ‘put’---at least, not yet.  But if he is, then it will likely lead to another leg up in the Market, but also blow an even bigger asset price bubble that ultimately will get popped.

My forecast:

Less government regulation, Trump mandated spending cuts, getting out of the Middle East quagmire and possible help from a fairer trade regime are pluses for the long-term US secular economic 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, the economic growth rate is slowing as the effects of the tax cut wear off, the global economy decelerates and the unwind (?) of the Fed’s balance sheet limits credit expansion.

       The negatives:

(1)   a vulnerable global banking [financial] system.  

As noted above, this week the ECB assumed administrative control of an Italian bank.  At the moment, this is a singular event.  However, I have persistently documented the balance sheet weakness of the EU banks.  I am not forecasting any further contagion, but the odds of one have almost surely increased.

(2)   fiscal/regulatory policy. 

Trade remains the most important near-term issue.  The big development this week was the announcement that US and Chinese trade officials will meet on January 7/8.   Clearly, the hope is that something meaningful will come out of this gathering aside from the ‘everything is awesome’ commentary that we have gotten out of the administration of late.  But if Trump remains firm on his intent to stop Chinese theft of intellectual property, I am not sure how much will be accomplished, given that the Chinese have shown little inclination to accede to that condition.  I believe that it is too soon to be tip toeing through the tulips.

However, congress isn’t waiting.

The other trade related events this week included [a] the lousy Chinese economic numbers [b] as well as the surprise lower earnings guidance from Apple which management attributed to China trade. This clearly doesn’t bode well for global growth absent a fairer trade regime.

The other issue is the government shutdown over funding of the border.  To me, this is more of a political than an economic matter.  First of all, it is not a total shutdown because much of the agency funding has already been done in other bills. So, its economic impact will not be as significant as it would be if the entire government were closed. Second, most of the funds not spent today will spent anyway when the standoff is over.  So, on a longer-term basis, little economic damage will be done.

Unless you are planning on getting that tax refund early.


Third, this more about who has the biggest Johnson in DC than it is about budgetary concerns.  The argument is over the difference between $1.6 billion versus $5 billion funding for ‘the wall’ in a budget that is running a trillion-dollar annual deficit.  That difference is a wart on a goat’s ass in the scheme of things.  Certainly, if this goes on for an extended time, some economic harm will occur.  But our political class watches the polls devotedly; so, my guess is that when it becomes clear who masses are blaming for the shutdown, a compromise will be sought.

I will spare you my usual rant about the weakening effects of an outsized federal debt/deficit on the economy.

(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.  

Two newsworthy items this week.  First, Trump began backing off of his criticism of Powell.  That likely will have little impact on the economy but is a plus for investors psychology.  How long that lasts is anyone’s guess.
                                                                                   
Second, Powell spoke at a forum at which both Yellen and Bernanke were in attendance.  His comments included [a] the economy continues to grow, [b] employment is expanding, [c] inflation is under control, [d] Fed policy, i.e. rate hikes and QT, is data dependent and it will adjust policy {including the unwind of its balance sheet} accordingly and [d] most important, the Fed is ‘listening to the Markets’---apparently meaning that the ‘data dependence’ of the Fed includes responding to an investor hissy fit. 

You know my bottom line on this issue: as long as the Fed continues a QT policy, liquidity shrinks creating credit funding problems and putting downward pressure on asset prices.  But if Fed policy has returned to being a hostage of the Market, then the current asset price adjustment may be over.  I continue to believe that whether the Fed is blowing bubbles or not, QE will not be impactful on the economy.

(4)   geopolitical risks: 

While the EU/Italians seemed to have worked a solution to Italy’s budget issue, the ECB’s assumption of control over an Italian bank could be disruptive to the completion of an agreement on the budget. 

The Brits still can’t figure out how to implement a Brexit and that is causing heartburn in the UK. 

US withdrawal from Syria and Afghanistan will almost surely have some effects on Middle East politics and the fight against terror.  As you know, I think that we should wall the whole region off and let them keep killing each other until no one’s left or they figure out that is not a good strategy.  Getting our own troops out may be the next best thing: it will save the lives and money: [a] if the US had all the money that it has spent in the Middle East for meager if any long-term benefit, how much better off would our fiscal situation be and how many young men would still be alive?  [b] why are we involved in an internecine Arab food fight?  We don’t need their oil.  What else do they have to offer us or the rest of the world?
Dates?

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

[a] the December EU manufacturing PMI was in line, though the composite PMI was below estimates,

[b] the December Chinese manufacturing, the Caixin and the Taiwan PMI’s fell into contraction territory; the December Chinese services and composite PMI’s were better than anticipated; November Chinese industrial profits fell 1.8%,

[c] the December Japanese manufacturing PMI was above estimates,

[d] the J.P. Morgan global manufacturing PMI hit the lowest level since 2016.
           
            Bottom line:  on a secular basis, the US economy is growing at an historically below average rate although I assume decreased regulation, the successful completion of the NAFTA 2.0 agreement and Trump’s spending cuts (assuming implementation) will improve that rate somewhat.  The long term positive potential from an altered Chinese industrial policy would have a meaningful effect on the US long term secular growth rate.

            However, these possible long term positives are being offset by a totally irresponsible fiscal policy.  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 the US’s long-term secular economic growth even with improvement from deregulation or the current trade regime (a caveat being if China does change its industrial policy).
          
Cyclically, the US economy is once again slowing.   Though (1) removing the uncertainty of no NAFTA treaty helps return economic conditions within the three countries to what they were before, (2) increase in Chinese purchases of soybeans and oil and the lower tariffs on autos and (3) a slowdown in the rise of short-term interest rates will help keep the slowdown under control.  On the other hand, a weakening global economy points to slower growth.  As a result of these factors, my guess is that my initial US 2019 economic growth rate assumption will likely change as their impact becomes more apparent.

          Finally, any move to a more dovish stance by the Fed is not likely to have an impact, cyclical or secular, on the economy.  QE II, III, and Operation Twist didn’t, and QE IV probably won’t either.

The Market-Disciplined Investing
           
  Technical

The Averages (DJIA 23433, S&P 2531) staged a powerful rally on Friday on good news on multiple front.  Still both indices finished below both moving averages.   The Dow finished in a very short-term downtrend and a short-term trading range. The S&P is in a short-term downtrend but negated (again) its very short-term downtrend. So longer term, there remains a lot of work to be done to re-establish an uptrend.  On the other hand, the indices failed to challenge their December lows and managed to mark both a higher low and a higher high.  That suggests more follow through to the upside, at least, near term.   

Volume was up; breadth positive.  But neither were impressive given the price action. 

The VIX fell 16%, but still ended above both moving averages and in very short-term and short-term uptrends.  So, its chart remains strong which is bad on stocks.

The long bond gave up all of Thursday’s gain but on much less volume.  It closed above its 100 DMA (now support), above its 200 DMA (now support) and in short and intermediate-term trading ranges and in a very short-term uptrend.  Nothing here to suggest rates aren’t going to continue to fall.

                And:
          

China’s shrinking trade surplus will have a negative impact on global interest rates and liquidity.

The dollar fell four cents, but remained above both MA’s, in a short-term uptrend and within the mid-November to present consolidation range. It was a bit usual for the dollar to be down so little on a huge risk-on day.

GLD move down ¾ % but still closed above both MA’s, within a very short-term uptrend and within a short-term trading range.

 Bottom line: so much for losing upside velocity.  With Friday’s monster advance, the trend question was turned on its head---instead of watching for follow through to the downside, we now wait to see how much follow through there is to the upside.  Further, with the indices having made a new higher low and higher high, they are now developing a very short-term uptrend---implying more upside, at least, in the very short term. 

While equity investors clearly got jiggy over a change in the economic outlook, others apparently need a bit more persuading:

 The long bond investors reacted as you might expect to the very positive jobs number (stronger economy = higher rates) and Powell’s more dovish tone (more accommodative Fed = less chance of a credit crisis).  Still the yield curve remains bent out of shape.  Like equities, watch the follow through.

            The dollar gave up just a tad of its ‘safety trade’ status; but not enough to be convincing.  The same with GLD.

Friday in the charts.

Fundamental-A Dividend Growth Investment Strategy

The DJIA and the S&P are still 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.  US economic activity is slowing, the strong jobs number notwithstanding; and the rest of the globe is slowing even faster than I, and most others, expected.

It is certainly possible, even probable, that the US can continue to grow as the rest of the world slows.  But declining global growth will still act as a drag on any improvement in earnings.  Certainly, that was the message from Apple this week.

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.  Having whiffed on NAFTA 2.0, the prospect of a meaningful change in the trade regime with China seems questionable.  But if it happens, it would be a major positive.  We should get some kind of read on progress following the January 7/8 trade meeting.

(3)   the rate at which the global central banks unwind QE.  The most disappointing economic news this week was Powell’s comments that suggested that the Fed was ‘listening to the Markets’ and would adjust policy accordingly---which is much like me saying that I will listen to my four-year-old granddaughter’s hissy fit and adjust my actions accordingly.  This kind of groveling before the Markets is what has been blowing financial bubbles since Greenspan initiated the Fed ‘put’.  However, ultimately, I believe that there will be a heavy price to pay for excess levels of debt, the financing of unproductive projects and lending to the those not creditworthy.

That said, until that bubble is ultimately burst, the equity Markets are likely going to prosper.  If Powell has reinstated the Fed ‘put’, it will become a significant factor in Market pricing just like it has been for the last five to six years.  Though to be clear, I think that there was enough ambiguity in his comments to question whether that has occurred.

I remain convinced that [a] QE has done and will continue to do harm 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. 

On final observation, when Volcker took over the Fed, his task was to reverse the irresponsible monetary policies of the prior regime.  Back then, the easy money had been used by participants to buy goods and services---driving up inflation which created a hue and cry from the electorate to which the ruling class had to respond.

In this round of Fed mismanagement, the easy money has been used to buy assets---leading to the mispricing and misallocation of assets.  Since those economic consequences are less visible to the electorate than inflation, QE can go on placating the Markets until something goes wrong in the economy and the electorate again raises a hue and cry---and the ruling class will have to respond.  What might it be?  Inflation, again?  No clue.  But I believe that it is inevitable.

(4)   current valuations. The recent sell off has begun to rationalize valuations in some Market sectors, offering buying opportunities.  And given the very recent pin action, investors may have decided to taking advantage of those opportunities. Still equity prices as defined by the major Averages remain very overvalued.

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.  Plus, if the Fed ‘put’ has returned that is likely to have a positive impact of stock prices.  On the other hand, I believe that overall fiscal policy (growing deficits/debt) will hamper economic and profit growth, restraining the E in P/E.

The math in our Valuation Model is getting more reasonable.  While the indices and some sectors of the Market remain overpriced, other sectors have been beaten like a rented mule.  As you know, I am focusing on that set of companies as potential buy candidates.  Quality companies whose stocks are down 50% or more should be bought.

That said, I believe that there is more pain to come; so, my purchases, for the moment, will be small.  Still this situation is what I designed my Valuation Model for---to buy low after having sold high.
           
            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                                               23433            2531

* 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.