The Closing Bell
1/27/18
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 23520-25964
Intermediate Term Uptrend 12885-29091
Long Term Uptrend 6222-29669
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2378-3149
Intermediate
Term Uptrend 1244-3058
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 positive: above estimates: weekly mortgage and
purchase applications, weekly jobless claims, month to date retail chain store
sales, the December Chicago national activity index, the January Kansas City
Fed manufacturing index, the December leading economic indicators; below
estimates: December existing home sales, December new home sales, the January
Richmond Fed manufacturing index, initial estimate of first quarter GDP, the
December trade deficit; in line with estimates: the January
composite/manufacturing/services PMI’s, December durable goods/ex
transportation.
However, the primary
indicators were slightly negative: December existing home sales (-), December
new home sales (-), January leading economic indicators (+) and December durable
goods (0). The call this week is neutral. Score: in the last 120 weeks, forty were
positive, fifty-seven negative and twenty-three neutral.
This is the third
week in a row of less than stellar stats.
Of course, three weeks don’t make a trend. Plus, many of the indicators were from
December which was before the tax cut and the sudden increase in corporate sentiment
and activity brought on by it. At the
moment, I am more focused on how large an impact the increased cap ex and
hiring have on the numbers than I am about the last three weeks of somewhat disappointing
data.
Indeed, this
week saw new announcements from other companies (J.P. Morgan, Home Depot,
Honeywell, Fed Ex, Comcast and Disney) of similar actions. While only four weeks old, the trend among
corporations of spending a portion of their tax savings on cap ex and hiring
seems to be gaining momentum. It is
still too soon to call this a trend; but the warning light is starting to
flash. If higher cap spending and hiring
continue, I will be raising my 2018 economic growth rate forecast for a second
time---and eating crow over my ‘not pro growth’ call on the tax bill.
Overseas, the data
remains upbeat---growth and improving business confidence around the globe. All
of this fits the developing theme of strength in the EU and improvement among
the other major economies. In short, the trend in global growth
remains positive.
In my mind, the
issue 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.
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 tax reform and infrastructure spending. While the tax bill was not perfect, much to
my surprise, we seem to be getting a much more pro-growth response to it 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 lead to any permanent increase in the long term
secular growth rate.
The dismal boom
(medium):
The
negatives:
(1)
a vulnerable global banking system. Nothing new this week.
(2)
fiscal/regulatory policy.
Several
factors were at play this week.
[a] the
continuing positive reaction by US businesses to the tax bill. Other companies announced higher cap spending
and hiring efforts this week. 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?
[b] part
of the answer is how aggressively the Donald pursues his trade threats. This week, he slapped tariffs on washing
machines and solar panels. I have made
clear that I am not a big fan of restraints on trade. However, to be fair, there was a lot more
bark in this announcement than bite. To
be sure, Wilbur Ross suggested that there are more tariffs to come. The issue will be their extent, which is to
say, are they adjustments to reflect economic reality or are they weapons of
economic destruction.
That
said, Trump said this week that the NAFTA negotiations were going fine---this
after saying that he would pull out.
Finally,
at the meeting in Davos, Treasury Secretary Mnuchin praised the weak dollar,
saying that it will help US companies. I
dwelled on this issue in Thursday’s Morning Call, so I won’t repeat myself
except for the bottom line---a weak dollar is not good for many companies, all
consumers and for the country in general. In addition sooner or later, the Fed will have
to respond to a falling dollar by raising interest rate irrespective of the
levels of US economic growth or inflation.
And:
[c]
another part of the answer is how our ruling class handles the current
budget/immigration bills which now appear joined at the hip. This crowd did manage to pass a continuing resolution
that keeps the government open for another three weeks---what an achievement,
not. Odds of some sort of compromise at
the expiration of this CR appears to have gotten lower because the dems have
backed out of an agreement on ‘the wall’.
Of course with this group, you never know what to expect.
The
problem is not so much the risk of a government shutdown which historically has
had little impact on the economy. The
problem is the debt ceiling needs to be raised in April and if this fight over
immigration pushes the CR to that deadline, then there could be serious
consequences, namely a government default on its debt.
Clearly,
April is a long way off; so much can happen in between. At the moment, this is just an alert.
[d] the
final issue is the shape of a $1 trillion infrastructure bill that was
announced this week, but with little detail.
I don’t have to tell you the impact of that kind of spending would have
on my thesis on debt and growth. Having
said that, I was wrong on the tax cut and I could be wrong here as well. Nonetheless, that is my operative thesis and I
am sticking with it.
You know
my bottom line, too much debt stymies economic growth even if it partly comes
from a tax cut. And a tumbling dollar is
not just bad for the country, it may push the Fed to be more aggressive in its
tightening policy. Not that I would
object; but the Market would.
(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 ECB met
this week and left its policy and narrative unchanged. What interests the Market the most is the
outlook for the beginning of the unwinding of QE---which is scheduled for
September. That remains on course, with
the usual disclaimers---if anything occurs that even looks like recession, QE
could be expanded.
On the other hand,
the Bank of Japan met and left its QE policy in effect for infinity.
And how about
those Swiss (medium):
The issue here
is, what does the Fed do if {i} the 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 and {ii} the dollar continues to get monkey
hammered. If the latter, 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.
You know my
bottom line: when QE starts to unwind, so does the mispricing and misallocation
of assets.
The destruction of honest price discovery
(medium and a must read):
(4) geopolitical
risks: Not much this week.
(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 January German investor sentiment soared,
while German business confidence was better than anticipated; the January EU
composite and services PMI’s beat estimates while the manufacturing PMI was
below,
[b] the December Japanese trade deficit fell while its
composite flash PMI hit a three year high.
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 a big
issue: the degree to which the recent corporate actions will lead to a
permanent pickup in secular economic activity.
So far the answer is to the positive.
However, we only have four weeks of data; so we need more time to
determine just how wide spread the increase in capital spending and hiring
becomes. In addition, the magnitude of
additional debt that will get loaded into the current budget negotiations in
order to secure its passage plus the cost of Trump’s (as yet unclear) new
infrastructure proposals are considerations to be factored into any economic
growth projections.
Further, the
potential fallout from a more aggressive trade policy and the administration’s
seeming lack of concern over a falling dollar could weigh on economic growth.
Still in the
short term, increased corporate spending on cap ex and hiring plus the
improvement in business and consumers psychology resulting from these moves
will likely add something to the cyclical growth rate.
Finally, there
is Fed policy and the impact that (1) a sudden improvement in economic growth and/or
(2) declining dollar could have on it.
On this part of my forecast, I haven’t changed. The central banks have 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 26616, S&P 2872) turned in another stellar performance on
Friday---the Dow continuing to trade above the upper boundary of its short term
trading range. Volume rose; breadth improved further. Long term, the Averages 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 (note: the S&P is now less than 100 points from that
boundary). The technical assumption has to be that stocks are going
higher.
The VIX declined,
switching once more in its on again/off again inverse relationship with
stock. It closed right on the lower
boundary of its recently reset short term trading range. Its pin action remains confusing.
The long
Treasury declined, putting it back below its 200 day moving average. That, at least partially answers the question
I posed yesterday. Which was the outlier?
Wednesday’s reset to resistance or
yesterday’s recovery. Still I would like
to see more follow through. TLT remains in a technical no man’s land.
The dollar fell,
despite all efforts to walk back Mnuchin’s ‘weak dollar’ comments. A weak dollar tends to imply lower interest
rates; the opposite of what is now happening.
So add one more bit of confusion to the overall technical back drop.
GLD rose,
trading more in line with UUP than TLT---just the opposite of Thursday
performance. While its chart continues
to look good, it still contributes to my technical uncertainty.
Bottom line: stocks
were back on their upward track on Friday. However, the VIX, TLT, UUP and GLD are
signaling mixed messages. How long
stocks can ignore this is the question; until they do, the current weight of
technical evidence is that they appear likely to go higher.
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. Although it will may 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 bank of China is
making noises that suggest a 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 the chance that the effects of the tax bill 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 26616
2872
* 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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