The Closing Bell
3/24/18
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 24290-26891
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 2452-3223
Intermediate
Term Uptrend 1254-3068
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 a slight upward bias to equity valuations. The
data flow this week was mixed: above estimates: February existing home sales,
month to date retail chain store sales, February durable goods orders, February
leading economic indicators; below estimates: new home sales, weekly jobless
claims, the March Market flash PMI’s, the fourth quarter trade deficit; in line
with estimates: weekly mortgage/purchase applications, the March Kansas City
manufacturing index.
The primary
indicators were definitely a plus: February
existing home sales (+), the February leading economic indicators (+), February
durable goods orders (+) and new home sales (-). The call is positive. Score: in the last 128 weeks, forty-four were
positive, sixty negative and twenty-four neutral.
Hard/soft data (short):
While this week
was only the third upbeat week in the last two months, it was by far the most
positive of those three. And we can’t
forget that blowout jobs report two weeks ago.
That doesn’t mean that the trend toward slowing economic growth is
changing. But there has been two solid
data weeks in the last three, so I have to be open to the possibility. Still my current thinking remains that (1) 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 and, thus, (2) the tax bill will not be proven
fairer, simpler or pro-growth.
Overseas, the data
was mixed. Most of the stats out of
Europe were less than upbeat; and the EU has been the bright spot in the global
economy. But like the US, one week does
not a trend make. So the forecast is unchanged but with the acknowledgement of some
cognitive dissonance,
The big item in
DC this week was the Donald ramping up the volume on trade---slapping $50
billion in tariffs on Chinese goods. I covered this in this week’s Morning
Calls as well as below. The bottom line
being that this action is, in my opinion, warranted, was way overdue but will
raise the risk of unintended consequences far more than the steel/aluminum
tariffs did.
Also Congress
passed a FY2018 spending bill, saddling the electorate with even more national
debt. Trump has announced that he/GOP
were going to propose a second round of tax cuts, which would only make matters
worse. Of course, this may just be part
of election year tactics. I have also
made myself clear on tax cuts at a time of high deficits/debt on numerous
occasions: increasing the deficit when the debt service costs are already high
inhibits not stimulates economic growth.
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 raised our economic
growth forecast. Many had hoped that 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 may have dwindled. Indeed, my original assessment of it may be
spot on, i.e. the bill was not fairer, simpler or pro-growth. 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. Nothing new this week.
When finance becomes parasitic (medium):
(2)
fiscal/regulatory policy.
Our ruling class really did
a number on the economy/electorate this week.
First,
congress passed a $1.3 trillion spending bill for FY2018 which will up the
deficit from FY2017 and, hence, further expand the national debt. On top of that the GOP is threatening to
introduce another round of tax cuts---though my hope is that this is just
election year engineering. I will save
you my usual harangue; but you know my bottom line: with the national debt
already at a stratospheric level, deficit spending and the resulting increase
in national debt will not be stimulative to the economy. Indeed, the cost of servicing that debt it
will have the opposite effect, slowing the rate of economic growth. (must
read):
Second,
on trade, there was some good news and bad news. Starting with the former, it appears the US
and NAFTA are making decent progress in revising that agreement. Ditto that with our EU trading partners over
the steel/aluminum tariffs. Then on
Friday, the Donald exempted even more countries. In other words, the longer we go, the less
vicious his bite.
The bad
news is that the faceoff with China was reached the stage at which someone must
blink. Trump has slapped $50 billion in
tariffs. China countered with $3 billion
in tariffs---not a very aggressive move.
It implies that the Chinese may be ready to negotiate. That said, late Friday, a Chinese official
said that there was more to come.
Based on
Trump’s prior ‘art of the deal’ tactics, my hope is that this confrontation
will get resolved behind the scene which will allow China to save face. The confounding thing about this particular
situation is that the Chinese theft of US intellectual property is by far the
most egregious violation of free trade that the US faces. Meaning that if the Chinese don’t provide
relief, then we may be about to have a gunfight with one of our largest trading
partners; and that won’t be good the US economy.
Again, you know my bottom line on this score. 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.
A trade war is a lose/lose proposition.
(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.
Center stage
was the FOMC meeting which included Powell’s first meeting as Fed chair. The results were pretty much as expected: it
raised the Fed Funds rate by 25 basis points and said that the unwind of its
balance sheet will continue as planned.
However, the Fed did strike a more hawkish tone as it raised its
estimates for the number of rate increases in 2019 and 2020.
It continued
its annoyingly upbeat assessment of the economy [I repeat, what numbers are these
guys looking at?]. Even if the economy is starting to improve
some, the trend has still been negative for the last two months. I don’t know if the members really believe their
narrative or they are just using it to move along the unwind of QE---hoping
somehow to get it done without wrecking the Markets. Good luck with that.
Another
concern along those lines is the recent rapid rise in LIBOR rates which roughly
$350 trillion in global debt is tied to.
I have linked to several articles on this issue. At the moment, those increases in rates
aren’t having much of an impact on US rates; and maybe they never will or they
will reverse themselves. But it is an
important enough development that it needs to be monitored.
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, [a] 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 or [b] if the US economy slips into
recession, it has few policy to tools to help alleviate its magnitude; and
Markets don’t like recessions.
(4) geopolitical
risks: Nothing new this week.
(5)
economic difficulties around the globe. The international data this week was a mixed
bag; but the concerning thing was the EU stats were largely negative. As you know, Europe has been the real bright
spot in globe, economically speaking. So
while it is way too soon to think that it is slowing, attention must be paid.
[a] February UK CPI was below consensus as was the
unemployment rate, while retail sales advanced; the March Markit EU PMI’s were
below estimates, March German business conditions were slightly better than
anticipated, though expectations were quite low.
The bottom line
remains the same: Europe gaining strength, though this week didn’t help that
view. Japan may be improving as is China.
Bottom
line: the US economy growth rate may 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---with the caveat that while this week’s numbers
from both the US and EU don’t fit that forecast, a one week countertrend is no
reason to alter it.
This week’s
turmoil on the trade face off with China was needed and was long overdue,
though there is an enhanced risk of unintended consequences. While Trump’s rhetoric may again be part of
his ‘art of the deal’ strategy, this time he is taking on a heavy weight. So reaching a viable resolution may entail a
rough ride.
That leaves the larger
fiscal issue (for me) which we know with certainty; that is, how the original tax cut, a second proposed new
improved tax cut, increased deficit spending and a potentially big
infrastructure bill will impact economic growth and inflation. As you know, I have an opinion (at the
current level of the national debt, bigger deficit/debt=slower growth; higher
deficit spending=inflation).
It is important
to note that the biggest negative here is not the impact that tax cuts and
increasing spending have on economic growth---though, in my opinion, they are a
negative. It is Fed policy. The central bank has created a no win
situation for itself: [a] if it does nothing and economy accelerates, it risks
inflation. In fact, if LIBOR rates continue to blowout and begin to impact US
rate, the Fed may not even have this option, [b] if does nothing and the
economy stumbles, it has few policy measures available to combat any economic
weakening, [c] if it moves forward with the unwind of QE, it will begin the unwinding
of the mispricing and misallocation 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 23533, S&P 2588) were pounded again yesterday. Volume rose, and breadth was negative. Both of the Averages closed below their 100
day moving averages for the second day; if they remain there through the close
next Monday, they will revert to resistance.
In addition, the Dow finished below the lower boundary of its short term
uptrend for the second day; if it remains there through the close next Monday,
it will reset to a trading range.
Finally, both are in very short term downtrends.
While equities
may be on the cusp of an important trend change, the current challenges have
yet to be successful; and there is still plenty of support lower down. In short, it is way too soon to be predicting
that a high has been made or that momentum is reversing to the downside.
The VIX was up
another 6 ½ %, ending above its 100 and 200 day moving averages and the lower
boundary of its short term trading range.
However, despite the moonshot over the last two trading days, it has not
yet established a very short term uptrend.
The long
Treasury was down fractionally---which seems a little off on a day in which
investors are worried about a trade war, global interest rates are rising and the
Fed just kicked the Fed Funds rate higher.
So there wasn’t any safety trade or interest rate worries reflected in
its pin action. That said, TLT is still
below its 100 and 200 day moving averages and in an intermediate term downtrend---indicating
higher rates in the offing.
The dollar was down,
like bonds, not an indication that it was being sought out as a safety
trade. While it is struggling to stabilize,
the trend remains down.
GLD soared 1 ¼%,
likely reflecting the concerns over a trade war. It remains above its 100 and
200 day moving averages and within a short term uptrend.
Bottom line: while
the technicals of the equity market point higher for the long term, some cracks
are starting to appear in that thesis.
Granted these may only be short term issues; but clearly, investors have
to be on alert, especially given the recent switch in psychology from ‘buy the dips’ to ‘sell the
rips’---which happened again on Friday.
I am confused by
yesterday’s aggregate pin action in TLT and UUP.
Friday in charts
(medium):
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. Plus a second round of tax cuts, in my
opinion, will not improve the outlook for economic growth, given the current
stratospheric level of debt. Further,
if Trump’s move in raising tariffs proves too aggressive, this would likely
have an adverse impact on growth---although I am all in favor of taking on the
Chinese over the theft of intellectual property issue.
This week, trade
remained center stage though it took on a more ominous tone from the
perspective of the Markets. As I said
above, I support Trump’s effort to reign in the Chinese pirating of US
intellectual property; but arriving at a resolution to this problem has so far
been rocky and there remains a decent risk of adverse consequences---which
clearly the Markets won’t (don’t) like.
The danger of subdued growth and higher
inflation was exacerbated this week with the passage of the FY2018 $1.3
trillion spending bill. Further,
Trump/GOP have announced their intent to pursue a second round of tax cuts;
although that could just be election year fluff. I needn’t be repetitive here; but my bottom
line is that the budget deficit and national debt are already too high to
render either deficit spending or tax cuts an effective growth stimulant. Making them bigger will only make things
worse. In short, in my opinion, Street
estimates for economic and profit growth are too optimistic and valuations will
have to adjust when that reality becomes manifest.
Finally, this
week’s action by the FOMC (raise interest rates, continue the unwind of the
Fed’s balance sheet) moves the Markets closer to the time at which the
elimination of QE, whether gradual or not, will also start the undoing of the
gross mispricing and misallocation of assets.
And, indeed, the blowout in LIBOR rates could be the first sign;
although it is still too soon to know.
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 in the first place;
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.
That said, even
if I am wrong on all the above points, 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 the need for the Fed to
normalize monetary policy. If improved
growth led to a continuing tightening of policy, ending QE, it, in my opinion,
would not be good for the Markets, since they are the only thing that
benefitted from QE.
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 still may be a chance that the effects of the tax bill could further
increase that growth assumption. Unfortunately,
(1) currently that effect appears questionable, (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 23533
2588
* 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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