The Closing Bell
1/20/18
Statistical
Summary
Current Economic Forecast
2018 estimates
(revised)
Real
Growth in Gross Domestic Product 1.5-2.5%
Inflation +1.5-2%
Corporate
Profits 5-10%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Uptrend 23465-25909
Intermediate Term Uptrend 12865-29071
Long Term Uptrend 6185-29632
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2371-3142
Intermediate
Term Uptrend 1243-3057
Long Term Uptrend 905-2963
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 an upward bias to equity valuations. The
data flow this week was slightly negative: above estimates: weekly mortgage and
purchase applications, weekly jobless claims, December industrial production;
below estimates: December housing starts, the January housing market index, January
consumer sentiment, month to date retail chain store sales, the Philly Fed
manufacturing index; in line with estimates: the January/revised December NY
Fed manufacturing index.
The primary
indicators were mixed: December industrial production (+), December housing
starts (-). The call this week is neutral. Score: in the last 119 weeks, forty were
positive, fifty-seven negative and twenty-two neutral.
This is the
second week in a row of less than stellar stats. Of course, two weeks don’t make a trend. Plus I think that the increase in sentiment
brought on by corporate reactions (increased cap spending and raising wages) following
the tax bill could start to show up in the economic data at some point.
Indeed, as I
noted in Thursday’s Morning Call, I believe that the positive changes in
corporate spending plans could potentially have a positive impact on economic
growth---assuming that they are an indication that other corporate entities
will follow suit. So at this moment, I
am not concerned by this week’s data. In fact, if cap higher spending and hiring become
the trend, I will be raising my 2018 economic growth rate forecast for a second
time.
Overseas, there
wasn’t a lot of data but what we got was largely upbeat---low inflation in
Europe and growth in China. All of this
fits the developing theme of strength in the EU and improvement in China (if
they are telling the truth).
In short, the
trend in global growth remains positive.
And it could be given a further boost by developments in corporate
spending patterns in the US. As I noted,
it is too soon to make that call; but I am hopeful. I continue to believe that the tax plan is
flawed (it is not simpler, it is not fairer and whether or not it is pro growth
is now the issue); but it appears, at least initially, that corporations don’t
see it as flawed as I do.
In my mind, the
issue still remains the magnitude and duration of this growth spurt. The key factors determining the answer to
that question are (1) the scale of the change in corporate spending plans, (2) how
much of a lid the current debt servicing requirements will place on the
economy’s growth potential, (3) whether
or not Trump makes good on his trade threats and (4) the Fed’s response.
As you know, I
have already raised my long term secular economic growth rate assumption based
on an improved regulatory environment. With
any meaningful follow through by the business community upping cap spending and
hiring plans, I will most likely do so for a second time. My issue isn’t whether the economy will keep
growing; my issue is by how much.
Our (new and
improved) forecast:
A pick up in the
long term secular economic growth rate based on less government
regulation. As a result, I have raised
our 2018 growth forecast. This increase in secular growth could be further
augmented by pro-growth fiscal policies including repeal of Obamacare and
enactment of (revenue neutral) tax reform and infrastructure spending. We may be getting the former; and much to my
surprise, we seem to be getting a much more pro-growth response to the tax bill
from corporate America than I had expected.
The latter is not yet in the forecast because it is simply too soon to
project a change of trend. And even
when, as and if it is, the question remains the degree to which the tax bill’s
lack of revenue neutrality will act as a governor on potential growth.
To be sure, short
term growth is improving, propelled by improved psychology and a pickup in
international growth. However, the issue
at present is, will the former will lead to any permanent increase in the long
term secular growth rate.
The
negatives:
(1)
a vulnerable global banking system.
Friday, it was reported that the Fed is working to
relax a key part of the post-crisis demands for drastically increased capital
levels at the biggest banks; a move that could free up billions of dollars for
some Wall Street giants.
Yeh, that is just what we need. Turn these guys loose to continue their good
work manipulating markets, developing questionable securities to pawn to the
public and generally lever up their balance sheets with risky assets.
Not good.
Jeffery Snider on our ‘fortress banks’ and the Fed
(medium):
(2)
fiscal/regulatory policy.
Several
factors were at play this week.
[a] the
continuing positive reaction by US businesses to the tax bill. I covered this above and to a greater extent
in Thursday’s Morning Call; so I am not going to belabor the point. The bottom line is that I am surprised {and
wrong} about corporate moves to date raising cap spending and increasing
hiring. If that continues, I will raise the
long term secular economic growth rate assumption---‘if’ being the operative
word. The question is, by how much?
Perhaps
the answer from the Atlanta Fed (medium):
[b] part
of the answer is how aggressively the Donald pursues his trade threats. I agree that some adjustments need to be made
in NAFTA and our trade relations with China.
My concern is that Trump pushes too hard and the result is diminished
trade---which would not be good for growth,
[c]
another part of the answer is how our ruling class handles the current
budget/immigration bills which now appear joined at the hip---a circumstance
that could only occur when politicians get involved. Unfortunately, there doesn’t appear to be any
good outcome to this problem: {i} a government shutdown (which we now know to
be the case) would not be helpful to the economy and/or {ii} a budget that
jacks up spending (deficit/debt) will only exacerbate the current debt service
problem. The best alternative would be
voting the continuing resolution into infinity; but why would this group of
yahoos do anything fiscally responsible?
You know
my bottom line, too much debt stymies economic growth even if it partly comes
from a tax cut.
(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 FOMC
released its latest Beige Book. It read
pretty much as expected: growth continues, the labor market is tightening.
zzzzzzzzzz
This week’s
real issue is, what does the Fed do if the surprising [to me] recent increase
in corporate investment and hiring turns out to be the real McCoy and we start
seeing a meaningful pickup in economic activity and inflation. Again, I covered its potential choices in this
Thursday’s Morning Call as well as every other missive I have ever
written.
The other
consideration which few are talking about is the shellacking that the dollar is
taking. If this continues, at some
point, the Fed is going to have to raise interest rates to stabilize the dollar
irrespective of how fast the economy is growing or how tame the rate of
inflation.
The bottom line
is that if growth picks up or the dollar continues to fall, the Fed has no good
alternatives. It has left itself in the
same place as every other Fed in the history of Fed; that is, it has waited too
long to begin normalizing monetary policy and now it must either hold to its
dovish ways and risk a big spike in inflation or begin to tighten policy more
aggressively and risk cutting off a potential increase in the long term secular
growth rate in the economy just as it is starting.
The Fed has
f**ked the pooch again. You know my bottom line: when QE starts to unwind, so
does the mispricing and misallocation of assets.
(4) geopolitical
risks: Not a lot occurred this week on
this subject. Perhaps the most
noteworthy was the continuing love fest between the two Koreas. I don’t mean to make light of it; because it
is positive.
(5)
economic difficulties around the globe. Which there seems to be less and less of. I know that I have said this before; but much
more of this, I am going to remove it as a risk.
[a] the December UK and EU CPI’s were in line,
December UK retail sales declined,
[b] December Chinese GDP was reported +6.8% versus
expectations of +6.7%, industrial production +6.2% versus 6.1%, retail sales
+9.4% versus 10.2% and fixed asset investment +7.2% versus 7.1%.
The bottom line
remains the same: Europe gaining strength, Japan may be improving as is China,
if we assume the data that it is reporting is reasonably accurate.
Bottom
line: the US economy growth rate appears
to be improving as a result of a combination of the positive impact on its
secular growth rate brought on by increasing deregulation, the better
performance of the EU economy, rising business and consumer sentiment stemming
from the passage of tax reform and could be helped further if the initial positive
actions by the business community turns into a trend.
And that is the
big issue before us: will the recent corporate actions lead to a pickup in
economic activity, and if so, does it have any legs? To be fair, I am less skeptical about the
impact of the tax bill than I have been and, hence, more hopeful (although I
stand by the thesis that this bill is not fairer or simpler; what is going to
be tested is whether it is more pro-growth than I thought).
However, we only
have three weeks of data; so we need more time to determine just how wide
spread the increase in capital spending and hiring becomes. In addition, (1) the results of the ongoing
trade negotiations with NAFTA and China, and (2) the magnitude of additional
debt that will inevitably get loaded into the current budget negotiations in
order to secure passage are considerations to be factored into any economic
growth projections. At the moment, I
need more information.
All that said,
while less regulation, more capital investment and improving wages (assuming it
occurs) will have a positive impact on the long term secular growth rate of the
economy, nearer term the elephant in the bathtub is Fed policy if growth and
inflation pick up and/or the dollar keeps getting pummeled. On this part of my forecast, I haven’t
changed. The central banks have
deliberately and with malice of forethought created a Hobson’s choice for
themselves: remain accommodative and risk higher inflation or tighten and risk
unwinding the mispricing of global assets.
Whatever the outcome, it will only confirm what I have said repeatedly
in these pages---the Fed has never in its history managed the transition from
easy to normal monetary policy correctly and it won’t this time either.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 26071, S&P 2810) were quiet most of the day, watching our ruling
class attempt to agree on a continuing resolution; then, they closed to the
upside as the chances of some agreement improved (ooops). Long term, they remain robust viz a viz their
moving averages and uptrends across all timeframes. Short term, they are above
the resistance level marked by their August highs, meaning that there is no
resistance between current price levels and the upper boundaries of their long
term uptrends. The technical assumption has to be that stocks are going
higher.
The VIX decline
8% on Friday, trading in its normal inverse relationship with stock prices for the
first time in a week. I have no opinion
on what this means. But follow through will tell us more.
The long
Treasury fell again, this time falling below its 200 day moving average (now
support); if it remains there through the close next Wednesday, it will revert
to resistance. While TLT remains in a
technical no man’s land, its recent pin action seems to be pointing to a
resolution on the downside (higher rates, stronger economy).
The dollar managed
a four cent rally which did little to alter its downhill slide. I see nothing positive about a falling dollar
and can think of a lot of negatives. For
one, it suggests loss of confidence in the US economy which is clearly
contradictory to euphoria being expressed by US investors. If it continues, at some point, the Fed will
have to step in to defend the dollar and perhaps aggressively (as in raising
interest rates), depending on the magnitude and rate of the dollar’s decline. That could play merry hell with the ‘measured’
unwinding of QE.
GLD moved higher,
though it is still challenging the lower boundary of its very short term
uptrend. Generally, GLD trades inversely
to the dollar but in line with the long bond.
So Friday’s pin action was open to multiple interpretations.
Bottom line:
investors appeared cautious Friday awaiting the results of the latest
congressional circle jerk. Whatever the outcome (which we now know), I don’t think
it will be enough to throw the technicals out of whack. Meaning that current weight of technical
evidence is that stocks appear likely to go higher. But the further the current ‘melt up’ goes,
the more tenuous that assumption becomes.
I remain
uncomfortable with the overall technical picture.
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’ has risen based on a
new set of regulatory policies which will lead to improvement in the
historically low long term secular growth rate of the economy. Further, there is the chance that the
economic growth rate could be even higher if the recent trend continues in
enhanced corporate spending stemming from the tax bill.
Consequently, I
raised my 2018 GDP, corporate profit growth and Fair Value estimates. And while I have expressed serious doubts
that the tax reform bill would do anything to further improve the long term
secular economic growth rate, the aforementioned pattern of increasing
investment and hiring seems to be proving me wrong. It is still too soon to alter my forecast;
but we should have enough data/experience in the first quarter to make that
call.
As I have
already said, I don’t believe that a more rapidly improving economy (1)
justifies current valuations and (2) may even exacerbate the real problem
facing the Markets---which is Fed policy/QE and the fact that, to the extent it
should have ever been used in the first place, the Fed has waited far too long
to begin unwinding it. We are likely at
or near the point where the Fed will be forced to make decision with no good
alternatives---either stay dovish and risk an escalation in inflation or put
the hammer down and risk truncating the current pickup in economic
activity.
I want to
reiterate a point related to the latter point; that is, I don’t believe that a
tighter Fed will cause a recession because QE did very little to help the
economy. But it will put a governor on
the rate of economic progress. However,
it will have a significant negative impact on equity valuations because that
was where QE had its positive effect. I
don’t know how the Market can go up on the presence of an easy Fed and also go
up in its absence; especially when it has led to the gross mispricing and
misallocation of assets.
At this point, I
couldn’t be more at odds with Market’s extremely positive sentiment grounded on
the assumption that the Fed has the Market’s back and will pursue the unwinding
of QE only to the extent that it does not disrupt the Markets. That may be true in the absence of a pickup
in growth or a continuing decline in the dollar or if the Fed was the only
central bank that was tightening---which, in fact, it has been up until
recently. Now the central banks of Japan
and China are making noises that suggest less accommodative monetary policy is
in the near future. Plus the ECB is
scheduled to begin shifting towards unwinding its own version of QE later this
year. To be sure, all these guys have mewed about tightening monetary policy
before and done nothing. And that may
prove to be the case this time around.
But whether it
does or not, it won’t change the fact that the global monetary authorities have
created huge asset price distortions just as they did in 2000 and 2008; and given
their abject failure to transition to normalize monetary policy in the past, I
doubt that they will do so this time. Unfortunately,
this time around those distortions are the most extreme in history; so I expect
the subsequent price adjustments will be very painful.
Bottom line: the
assumptions on long term secular growth in our Economic Model have improved as a
result of a new regulatory regime. Plus,
there is a ray of hope that fiscal policy could further increase that growth
assumption though its timing and magnitude are unknown. On the other hand, (1) if Trump follows
through with his trade threats, and/or (2) the deficit/debt continues to rise,
I believe that it would negate or, at least, partially negate any potential
positive. In any case, I continue to believe that the current Street narrative is
overly optimistic---which means Street models will ultimately will have to lower
their consensus of Fair Value for equities.
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.
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 the current price strength to
sell a portion of my winners and all of my losers.
DJIA S&P
Current 2018 Year End Fair Value*
13860 1711
Fair Value as of 1/31/18 13266
1637
Close this week 26071
2810
* 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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