2/17/18
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 Uptrend 23840-26316
Intermediate Term Uptrend 12986-29192
Long Term Uptrend 6222-29669
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2397-3168
Intermediate
Term Uptrend 1251-3065
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 weighed to the negative: above estimates: January
housing starts, weekly jobless claims, February preliminary consumer sentiment,
the January small business optimism index, the February Philly Fed
manufacturing index, December business inventories/sales; below estimates: weekly
mortgage and purchase applications, month to date retail sales, January retail
sales, January industrial production, the February NY Fed manufacturing index, the
January budget surplus, January CPI and PPI, January import/export prices; in
line with estimates: the February housing market index.
The primary
indicators were also negative: January housing starts (+), January retail sales
(-) and industrial production (-). The
call this week is negative. Score: in
the last 123 weeks, forty-two were positive, fifty-eight negative and twenty-three
neutral.
We are now on a
seven week roll in which the stats trend has been downbeat---following a brief
period of very positive data. As you
know, I attributed the latter to a much better corporate response to the tax
cut than I had anticipated. However,
since then (1) the initial surge in upbeat wage/cap spending announcements have
tapered off dramatically and (2) as has the aforementioned trend in economic stats.
I am not yet
ready to return to my original assessment (that the tax bill was not fairer,
simpler or pro-growth), but I am certainly leaning that way. And it does appear that the brief period of
above average growth may be attributable to the recovery activity from the
earlier hurricanes and wild fires. The
longer we go without any sign of economic improvement from either the tax bill
itself or the increase in individual/corporate psychology, the more likely I am
to reiterate my first opinion.
Further, I think
it important to note that many of the recently reported price/inflation numbers
have shown an increase. At the moment,
the trend is too short to prompt any change in our inflation forecast. However, I will be paying close attention to
this data because of their implication for Fed policy.
I also want to
make one important distinction. There is
little doubt that corporate earnings will advance markedly in 2018 as a result
of the tax bill. But that is not
economic growth; it is simply a one-time improvement in the level of
profits. It won’t result in expanded economic
growth unless those higher earnings are utilized to raise productivity versus
being spent on dividends, buybacks and acquisitions. Initially, it appeared as if the former was
going to occur. Now not so much. The point being, don’t confuse a single year’s
higher earnings with an increase in the secular growth rate of corporate
profitability.
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.
The big items in
DC this week were the Donald’s new infrastructure bill (all talk and little
do), his FY2019 budget (throwing a balance budget under the bus, but DOA), a
proposal to increase the gasoline tax (the first sensible idea in a long time)
and initial action to impose tariffs on Chinese cast iron soil pipe (if the
numbers are correct, a reasonable step).
So there has been a lot to digest.
All in all, the spending
proposals create the potential for additional deficit spending; but at this
moment, it is tough to figure the magnitude of any final package. So it is too soon to suggest that the
deficit/debt problem is going to get any worse than it already is. In fact, if the gasoline tax is enacted, it
would be a welcome addition to any infrastructure legislation. Nonetheless, any increase in deficit spending
would likely exacerbate the forces behind an inflationary impulse that may
force the Fed to tighten much quicker and much further than it wants.
Finally, as you
know, I am a big fan of free trade, so I take notice at the proposed action this
week by the US against China on cast iron soil pipes. That said, (1) I have no clue how big that market
is; but if the worse happens, I don’t think that it would be earth shaking, (2)
the action is an appeal to the international trade commission; so there is a
litigation process that could deny the US claims and nothing would occur and
(3) if the Chinese are selling this product as far below cost as the US claim
suggests, this is probably a reasonable step to take.
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 initially received a much more pro-growth response to it from
corporate America than I had expected. However,
the latter is not yet in the forecast because (1) it is too soon to project a
change of trend and (2) what trend there was seems to have fizzled. And even when, as and if it does, the
question remains the degree to which the tax bill’s lack of revenue neutrality will
act as a governor on potential growth.
The
negatives:
(1)
a vulnerable global banking system. Nothing new this week.
(2)
fiscal/regulatory policy.
The Donald
was busy this week and not in a particularly positive way. He released his infrastructure plan which had
some sizzle [$1.5 trillion in spending] but little steak, to wit, only $200
million would come from the feds, leaving the rest to state and local
governments [which are just as broke as the federal government but can’t print
money] and private enterprise [which I assume won’t invest in anything that
doesn’t economically benefit it]. That’s
the good news.
The bad
news is Trump also submitted his FY2019 budget which proposed more deficit
spending with no pretense of being in balance in ten years. That would only make containing higher
interest rates or inflation harder.
There is a silver lining---virtually everyone has declared it dead on
arrival. Nonetheless, it is out there
and something to be negotiated against; meaning with the end result of the
Donald’s budget being more deficit spending, it leaves plenty of room for
congress to argue over its content but still end up a higher deficit.
The Donald
also suggested that he would approve an increase in the gasoline tax. Since this is a ‘user’ tax, I think it makes
a lot of sense as a source of funding for infrastructure spending---as long as
it doesn’t serve as a rationale for more deficit spending. That said, virtually the entire Washington
establishment has poo pooed the proposal.
You know
my bottom line, too much debt stymies economic growth even if it partly comes
from a tax cut. And a rapidly expanding
deficit and a tumbling dollar are not just bad for the country, they 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 only news
this week from the gurus in the Eccles Building was the speech by new Fed chief
Powell at his swearing in ceremony in which he vowed to be alert to financial
stability risks, i.e. the Fed will still have its eye on the Markets [even
though there is no mandate to do so].
The bottom line
is that if growth/inflation picks up and/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, if
there is an increase in inflation, 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 trashing the Markets.
You know my
bottom line: when QE starts to unwind, so does the mispricing and misallocation
of assets.
Another ear
burner from Jeffrey Snider (medium and a must read):
(4) geopolitical
risks: More unicorns in South Korea.
(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] fourth quarter EU GDP was strong as was December
industrial production; January UK inflation was above the BOE’s goal while
retail sales were disappointing,
[b] fourth quarter Japanese was much stronger than
anticipated.
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 faltering once again despite the positive impact on its secular growth
rate brought on by increasing deregulation, the better performance of the EU
economy and rising business and consumer sentiment.
However, the big
issue right now is how will the tax cut and increased deficit spending impact
economic growth and inflation. And that
is not factoring in a big infrastructure bill and/or the potential fallout from
a more aggressive trade policy. As you
know, I have an opinion (bigger deficit/debt=slower growth; higher deficit
spending=inflation) but given the initial unexpected positive corporate actions
following the tax cut, I am, at the moment, a bit wary of pushing the point too
hard.
It is important
to note that the real negative here is not the impact that tax cuts and
increasing spending have on economic growth; it is how they might affect
inflation and as a result Fed policy. 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 25219, S&P 2732) were up slightly on Friday, finishing above both
moving averages and within uptrends across all major timeframes. Volume
continues to drop (a bit concerning in a strong rally); breadth was positive. The technical assumption is that long term
stocks are going higher; though the Averages need to overcome their former
highs before we have an all clear signal.
The VIX was up,
bouncing off a support level and remaining at an elevated level, suggesting
that there is no end to the recent volatility.
The long
Treasury inched higher, but still finished below both moving averages, in very
short term and short term downtrends and very near the lower boundary of its
long term uptrend, a breach of which would clearly intensify investors’ concern
about rising interest rates/inflation
The dollar was
up, having bounced off of a support level.
Nonetheless, it ended below both moving averages and in an intermediate
term downtrend. This remains an ugly chart.
GLD was off
slightly. It had a good week, bouncing
off a minor support level and leaving its chart in relatively good shape.
Bottom line: equity
investors seem to have shaken off their concerns over higher inflation/interest
rates as well as the weak economic data.
That suggests that they are assuming that the pickup in CPI and PPI will
be short lived or contained and the poor numbers will keep the Fed
accommodative---which I disagree with but could respect if not for the contrary
behavior of TLT, UUP and GLD. Their pin
action notwithstanding, the technicals of the equity market point higher.
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.
With respect to
the latter, we have gone another week in which there were no major additional
spending plans announced. That doesn’t
mean that we won’t see a further pick up in this kind of activity. However, if we don’t, then I think the impact
of the tax cut on the economy will not be enough to prompt an increase in my
long term secular economic growth rate---which means I may not be as wrong
about the tax bill’s impact as it appeared three weeks ago.
To be clear, it
will affect 2018 corporate earnings positively; but for the growth rate of
those profits to accelerate, at least some of the funds must be directed at
enhanced productivity. And right now, I think
that issue remains a question---meaning that while a one-time increase in
profitability will result in a one-time increase stock prices (assuming a
constant P/E), it will not increase the multiples (P/E’s) themselves or the
rate of earnings growth.
The more
important thing to focus on at the moment, is the overall effect of the tax
bill, the short term budget agreement, the infrastructure plan and Trump’s
FY2019 budget both on secular and cyclical growth and inflation. Until I have a better handle on this, I am
holding off on any increase in my long term growth outlook---which puts me at
odds with a generally more optimistic view from the Street. The key to that disagreement centers on how
much growth versus how much inflation the aforementioned factors will generate. My position is that the economy is too
burdened with debt for there to be much real growth generated by these
measures; and hence, the majority of any impact will be on prices.
That said, even
if I am being too conservative, I don’t believe that a more rapidly improving
economy justifies current valuations and may even exacerbate the real problem (in
my opinion) facing the Markets---which is Fed policy/QE and the effect an
inflationary impulse would have on its current ‘tighten as long as the Markets
remain calm’ policy. In other words, the
need to control inflation may trump the best laid plans. That is not my forecast, at least, at the
present. But if it occurs, it will be a
carbon copy of every other time the Fed was forced to move aggressively against
inflation because it waited too long to normalize monetary policy in the first
place.
I want to
reiterate the point that I don’t believe that a tighter Fed will cause a
recession because QE did very little to help the economy. Although it may act as 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.
That said, the
pin action this week tells me that opinion is at odds with the Market. Having been chastened a bit by the initial
corporate response to the tax bill, I recognize that I could be wrong on this
contrarian view.
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) currently that effect
appears to be dwindling, (2) if Trump follows through with his trade threats,
and/or the deficit/debt continues to rise driven by the recently announced
spending proposals, I believe that it/they would negate or, at least, partially
negate any potential positive. More debt will inhibit not enhance growth and
will likely create inflationary pressures which will have to be dealt with by
the Fed, sooner or later. 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 2/28/18 13315
1643
Close this week 25219
2732
* 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.
