The Closing Bell
3/10/18
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 24087-26688
Intermediate Term Uptrend 13057-29262
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2417-3188
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 slightly negative: above estimates: month to date
retail chain store sales, the February ADP private payroll report, February
nonfarm payrolls, the February ISM nonmanufacturing index; below estimates: weekly
mortgage and purchase applications, February retail chain store sales, weekly
jobless claims, January wholesale inventories/sales, the January trade deficit;
in line with estimates: the February Markit services PMI, December/January
factory orders, fourth quarter productivity/unit labor costs.
The primary
indicators were slightly positive: February
nonfarm payrolls (+), December/January factory orders (0) and fourth quarter productivity/unit
labor costs (0). I was tempted to call
the week a neutral but the overwhelmingly positive jobs report pushed me to the
positive side. Score: in the last 126
weeks, forty-three were positive, fifty-nine negative and twenty-four neutral.
This is only the
second up week in the last nine; and it was just barely so. And it does nothing to change my current
thinking: the initial surge in economic activity following the tax bill was
more likely attributable to post hurricane/wild fire recovery spending than the
much touted jump in wages/cap ex spending.
Just a note on
that jobs report---it wasn’t just the headline number of stronger job growth that
was positive (which would suggest a more aggressive tightening Fed). It was also the expansion in the labor force
participation rate coupled with the lack of wage growth. In other words, employment is rising but
largely due to the return of those dropouts that economists have been so gloomy
about; and they are rejoining the labor force not because of higher wages but
because of more jobs. If that trend
continues (i.e. rising employment, increased participation rate and stable
wages) that would be a big plus for noninflationary economic growth and would
cause me to raise my forecast for long term secular growth. But this is one number. More is needed before I would consider such a
change.
My favorite
optimist on Friday’s jobs report (medium):
Still 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. Clearly, 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 revert to my original
opinion (Friday’s jobs report notwithstanding).
I do want to reiterate
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
was mixed at best. This is the first bit
of cognitive dissonance we have gotten in a while on the global outlook. At this point, I have to view it as a one-off
occurrence though clearly we have to be attentive to the potential of a change
in trend.
The big item in
DC this week was the Donald’s tariff theater in the round. After much huffing and puffing, including the
resignation of Cohn, the finale was simply an announcement, no action---that
comes later it seems. In essence, he
told the world his intent, then gave most of it the opportunity to make him a
better deal than the US now has. Of
course, that doesn’t mean that the US will get a better offer; but, at least,
there is more reason to Trump’s approach to trade than first appeared. The results of this ‘art of the deal’
strategy are still to be determined.
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. However, it appears that the positive effects
of the tax bill have quickly dwindled. Further, Trump’s approach to free/fair
trade is stomach churning and while he appears more circumspect than originally
thought, we still don’t know whether or not it will result in a trade war in
the end. At this point, our forecast remains
economic growth at a slightly better long tem secular rate but still below
historical standards.
The
negatives:
(1)
a vulnerable global banking system. Congress is now attempting to roll back
provisions of Dodd Frank, one of which will loosen the restrictions on large
bank trading desks. I needn’t remind you
that this is the group of clowns that played a major role in the 2007 financial
crisis and that to date, no one has been reprimanded, punished or gone to
jail. So I pose the question, why would
they act any more responsible this time around?
(2)
fiscal/regulatory policy.
The main
focus this week was on trade; specifically, the Donald’s intent to impose
tariffs on steel and aluminum imports.
Forgetting for a second the math as it pertains to this action, the more
important issue as I posed it, is how this scenario plays out: [a] is Trump right
about the extent of price cheating and that there will be little response, [b] is
he about to start a real trade war or [c] is all this theater just part of the
Donald’s ‘art of the deal’ negotiating strategy.
Despite the
resignation of Gary Cohn, a leading in-house
advocate of free trade, and the apparent ascendancy within the administration
of the pro-tariff crowd, Trump’s Thursday ‘proclamation’ appears to signal that
he is much more rational on this issue than many [including me] may have
thought. In short, alternative [c] seems
to be most likely outcome at this point.
You know
my thoughts on trade---the freer, the better with the caveat that there are
always cheaters that must to brought to task.
The math
of a trade deficit (medium and a must read):
The
latest response from China (medium):
My
bottom line: free trade is a significant economic positive, a fact that has
been too well substantiated by history. Any
move toward a trade war would economically damaging to the US.
Free
trade versus capital flows (medium and today’s must read):
I said nothing above about a huge concern of
mine---the direction of fiscal policy; which is to say, higher spending and tax
cuts at a time of historically high budget deficits and national debt. Again,
you know my bottom line on this score also. 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.
(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 Fed
released its latest Beige Book this week; the bottom line of which was that the
economy was humming which is leading to upward pressure on wages and
prices. This sounded to me like an
advance ad for, at the very least, a continuation of the unwinding of QE and
perhaps a hint that a more aggressive policy is coming.
In these notes,
I regularly relay published data that scarcely portrays an economy progressing
as well as the Fed Beige Book implies; and I have said repeatedly in these
pages that I have no idea what information the Fed is using to glean its rather
upbeat assessment of the economy.
Not that is
going to matter in the end. If the economy
is doing as well as the Fed says, then it will most likely continue to unwind
QE and perhaps at even a more aggressive rate than is currently forecast. And if my current operating thesis is correct,
then the unwinding of QE will also result in the unwind of the asset mispricing
and misallocation that has gone hand in hand with QE. On the other hand, if the
economy is not doing as well as the Fed says but the Fed continues to unwind QE,
then it will make the unwind of QE all the more quick and intense.
In other
central bank news, BOJ governor Kuroda hinted that the end of Japanese QE may
be near; then when markets reacted negatively, quickly walked back his
statement. At a BOJ meeting two days
later, he reemphasized the QE forever mantra.
Also, the ECB
met and left rates unchanged. In its
formal statement, it did, however, drop language stating that it could increase
QE if necessary---which gave it a slightly more hawkish tone.
The bottom line
is that 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 trashing the Markets.
(4) geopolitical
risks: representatives from South and
North Korea met this week. In the
process, the North Koreans claimed that they would be willing to denuclearize,
if the country’s safety could be insured. Plus Kim Jong Un issued an invitation
to Trump to negotiate a resolution to nuclearization versus safety problem---which
he accepted. It sounded oh so
hopeful. Just remember that we have
heard this tune from North Korea before and look where it got us. Furthermore, we have no idea how related this
move is to the coming trade confrontation between China [North Korea’s primary
sponsor and defender] and the US.
(5)
economic difficulties around the globe. For the first time in a long time, the global
economic data did not make for particularly good reading. Given the strength of what has recently been reported,
this is likely a hiccup. But it bears watching.
[a] the February EU composite PMI was below
expectations; the February German trade surplus was larger than consensus but
factory orders and industrial production were down significantly; February UK
retail sales were below forecast but industrial production and factory orders
were above,
[b] the February Chinese composite PMI came in lower than
anticipated; February Chinese exports soared up 44.5% while imports rose 6.3%;
February CPI was higher than anticipated while PPI was lower.
The bottom line
remains the same: Europe gaining strength, Japan may be improving as is China, with
the caveat that this week’s poor performance has been duly noted.
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.
This week’s
turmoil on trade could prove to be a negative.
However, it appears that all the tough rhetoric was just part of Trump’s
‘art of the deal’ strategy. Not that the
US won’t end up in a trade war; but I think the probabilities of one are less
than I did last Monday.
That leaves the larger
issue (for me) which we know with certainty; that is, how will the tax cut,
increased deficit spending and a potentially big infrastructure bill impact
economic growth and inflation. As you
know, I have an opinion (bigger deficit/debt=slower growth; higher deficit
spending=inflation).
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 bank has created a Hobson’s choice for itself: 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 25335, S&P 2786) responded enthusiastically to a near perfect jobs
report. They ended just short of their
prior high; so, on Monday, I will be interested to see if they can close above
that high or retreat. Volume was up, but not a lot and it remained at a low
level. Breadth improved slightly;
certainly not as much as I would have thought.
Plus the flow of funds indicator looks poised to break an uptrend. That said, the Averages are above both moving
averages and within uptrends across all major timeframes. The technical
assumption is that long term stocks are going higher. However, the indices are now stuck in a
narrowing range defined by lower highs and higher lows. In addition, they need to overcome their
former all-time highs before we have an all clear signal.
The VIX fell another
11 ½ %, ending below the lower boundary of its short term uptrend for a second
day; if it remains there through the close next Monday, the trend will reset to
a trading range. This pin action may be anticipating a
drop in volatility, which would be a plus for stocks.
The long
Treasury fell, apparently unimpressed with the jobs report or any increased
likelihood of an easier Fed. It inched
closer to its only remaining support level (the lower boundary of its long term
uptrend) which if breached, would clearly intensify investors’ concern about
rising interest rates/inflation
The dollar was
off fractionally, also seemingly unmoved by the jobs report. It remains an ugly chart.
GLD was up
slightly, also lacking the enthusiasm of stocks. Though unlike TLT, it was in agreement with
them. Momentum remains to the upside, but it must still overcome a very short
term downtrend.
Bottom line: the
technicals of the equity market point higher for the long term; very short
term, we should get more information on Monday with the Averages poised to
either challenge their prior high or bounce off it. TLT, UUP and GLD didn’t get jiggy with the
jobs report and TLT even pointed at no change in Fed policy (unwinding QE).
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. Unfortunately, the recent decline in the
strength of economic activity suggests that any benefit from enhanced corporate
spending stemming from the tax bill was short lived. Further, if Trump’s move in raising tariffs
proves too aggressive, this would likely have an adverse impact on growth.
This week we
added a potential trade war to the worries regarding 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. With regard to the former, it appears that
much of Trump’s bluster was intended to elicit the best offer possible in
adjusting steel/aluminum prices from our trading partners---not the hell bent
rush to impose tariffs that it initially appeared to be.
With respect to the latter, my concern
remains on how much growth versus how much inflation the aforementioned factors
will generate. As you know, 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, the near perfect jobs report under mines that notion. But it is only one number; so I need more
along that line me to alter my position.
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 improved growth. 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.
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. That math is simply: 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 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 3/31/18 13375
1650
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
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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