Saturday, April 14, 2018

The Closing Bell

The Closing Bell


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 Trading Range                      21691-26646
Intermediate Term Uptrend                     13123-29328
Long Term Uptrend                                  6410-29847
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2475-3246
                                    Intermediate Term Uptrend                         1265-3080
                                    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%

The Trump economy is providing a slight upward bias to equity valuations.   The data flow this week was negative: above estimates: March CPI,  March import prices; below estimates: weekly mortgage and purchase applications, month to date retail chain store sales, weekly jobless claims, April consumer sentiment, February wholesale inventories/sales, the March small business optimism index, March PPI; in line with estimates: none.

  There were no primary indicators.  Given the overwhelming count of negative versus positive stats, the call is negative: Score: in the last 131 weeks, forty-four were positive, sixty-two negative and twenty-five neutral---confirming my current forecast.

The overseas numbers were also negative.  The most important is the continuing trend (now four weeks) of poor data from the EU.  As you know, Europe has been the bright spot in the global economy and a positive factor my forecast of an improving US economy.  That notion is now being seriously tested.

The ruling class provided its usual dose headline grabbing events---all of which I have covered in Morning Calls and below: the ongoing battle of words between Trump and Xi on trade (potentially bad, but probably not), the ongoing battle of words between Trump and Russia over Syria (potentially bad, but probably not), Trump’s supposed move to rescind (I know, I have been using the wrong spelling) parts of the recent spending bill (potentially good but not great) and the release of the Fed minutes (potentially good for the economy but bad for the Market). 

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 that growth forecast. There is the potential that Trump’s trade negotiations could also lead to an improvement in our long term secular growth rate---though that has yet to be determined.  On the other hand, the tax cut and spending bills as they are now constituted are negative for long term growth (you know my thesis: at the current high level of national debt, the cost of servicing the debt more than offsets any stimulative benefit). 

On a cyclical basis, the economy appears to be rolling over, having achieved one of the longest growth cycles in history.  In the short term that will overwhelm any benefit to the long term secular growth rate. 

       The negatives:

(1)   a vulnerable global banking system.  

The bankster misdeeds continue (short):

S&P puts Deutschebank of credit watch negative (medium):

(2)   fiscal/regulatory policy.  

Trade remained center stage this week with much back and forth between China and the US.  I have gone over it all in our Morning Calls, so I won’t repeat myself; but the bottom line is that I believe that the Trump ‘art of the deal’ negotiating style will not precipitate a trade war and that the US will likely benefit from revised trade agreements with China and NAFTA.  I am just not sure how much.

Latest from China (short):

The other item worth mentioning is that Trump said that he wanted to rescind some of the spending contained in the ginormous FY2018 budget act.  Apparently, he is getting some negative feedback from the heartland.  To be sure, something is better than nothing.  But his proposed cuts of a couple hundred million dollars aren’t going to have a major impact on the growth of the deficit/debt which, in turn, does little to alter my thesis that fiscal policy will prove a drag on economic growth.  [And not to be too cynical, I have to wonder if this move is more about the 2018 elections than a real sense of fiscal profligacy.]

Again, you know my bottom line on this score.  Too much debt stymies economic growth even if it partly comes from a tax cut or infrastructure spending.  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.  

The Fed released the minutes of the March FOMC meeting on Wednesday--- which, bottom line, were just a tad hawkish or as one pundit put it, the Fed is  ‘moving into a non-accommodative stance’.  (must read): 

As you know, I have been a longtime advocate of unwinding QE; indeed, I believe that it should have started years ago.  It has led to the mispricing and misallocation of assets which hamper long term economic growth.  So a more hawkish Fed, in my opinion, is a plus long term.  Short term is the problem.  It has waited so long to begin the normalization of monetary policy that it is executing it at the point where the economy appears to be at or near rolling over.  Certainly, the data support that---the hopey, feely statements out if the Fed notwithstanding.  Tightening monetary policy, especially if forced to do so by rising inflation, as the economy decelerates adds fuel to any downward momentum and is not and has never been a formula that is Market pleasing.

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:  The US/Russian faceoff in Syria:

***overnight, hopefully, this is now over and there is no aftermath (medium):

The circle of absurdity (medium):

(5)   economic difficulties around the globe.  The international data this week was negative.

[a] March UK household spending was very disappointing as was EU industrial production,

[b] March Chinese PPI and CPI were below estimates and, in March, it showed a trade deficit,

[c] global PMI fell to a sixteen year low.

The bottom line remains the same: Europe gaining strength, though the yellow light is flashing on that assumption; Japan may be improving as is China, but again the recent numbers don’t reflect that.
            Bottom line:  the US economy growth rate may be faltering once again despite the positive impact on its long term secular growth rate brought on by increasing deregulation.

On the other hand, if the success of the trade negotiations with South Korea are an indication that Trump’s ‘art of the deal’ negotiating style can produce further positive outcomes with NAFTA, the EU and China, then a fairer trading regime would almost certainly be a plus for the long term secular economic growth rate.  ‘If’ being the operative word, though the road to achieving any success could a rough one.

That leaves the larger 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, a bigger deficit/debt=slower growth; higher deficit spending=inflation, even if they are the result of a tax cut and/or infrastructure spending.

It is important to note that the negative from the impact that tax cuts and increasing spending have on economic growth is not the only one.  The other 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 rates, 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

The indices (DJIA 24360, S&P 2656) were down yesterday on flat volume and poor breadth.  Both of the Averages closed within very short term downtrends (having made a fourth lower high on Tuesday) and below their 100 day moving averages (now resistance).  They both remain above their 200 day moving averages.  The DJIA finished in a short term trading range but in intermediate and long term uptrends.  The S&P is in uptrends across all timeframes. The short term technical picture remains cloudy; but longer term, the assumption is that equity prices will continue to rise.

                The VIX was down another 6 %, really unusual for a down Market day but in line with several other days this week in which it traded contrary to its normal inverse correlation.  Still it ended in a very short term uptrend, above its 100 and 200 day moving averages and the lower boundary of its short term trading range---reflecting the obvious fact that volatility hasn’t gone away. 

The long Treasury was up, remaining within what is now a strong two month long bounce (very short term uptrend) off the lower boundary of its long term uptrend.   On the other hand, it continues to trade below its 100 and 200 day moving averages and in a short term downtrend.  It is starting to get squeezed between the lower boundary of its very short term uptrend and its moving averages.  A break in this narrowing range would likely point at a further move in the direction of the break.

The dollar was unchanged on heavy volume, finishing below its 100 and 200 day moving averages and in an intermediate term downtrend.  UUP continues to trade in a very tight range, which is not usual when bonds are moving big directionally.
GLD was up, finishing above the lower boundary of its short term uptrend and its 100 and 200 day moving averages.  On the other hand, it has been unable to rise above its February high.
Bottom line: near term the direction of equity prices is in question.  As I noted Thursday, the indices are starting to get squeezed between their very short term downtrends and their 200 day moving averages---which they have already unsuccessfully challenged four times.  

History suggests that a break out of this narrowing pennant like formation will set the course of the Market in the direction of the break.  If it is to the upside then it would support the assumption that the stock prices remain in a long term uptrend.  If to the downside then it would weaken the bull case and set up a decline to the lower boundaries of the DJIA’s short term trading range and the S&P’s short term uptrend.  That said, the Averages have plenty of support at lower levels. 

The price movements yesterday in TLT, UUP and GLD pointed at a weakening economy---the reverse of Thursday’s pin action.  Their performance remains confusing.

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.  A further increase could come if Trump’s drive for fairer trade is successful. 

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 neither a second round of tax cuts nor additional infrastructure spending, in my opinion, will improve the outlook for economic growth, given the current stratospheric level of debt.  Of course, some republicans are having buyer’s remorse over the recent deficit ridden budget---as well they should.  Whether they can or will so anything about it remains to be seen.  Even if they do, deficits and debts have risen to such an extent the economic growth will be labored.  I don’t believe that is reflected in the price of stocks.

Trade remained center stage with our negotiations with China the star.  Rhetoric aside (as confusing as it may be), I believe that the Donald has revealed enough about his ‘art of the deal’ negotiating style to be somewhat optimistic.  I am hopeful that this whole process will be proven successful and pro-growth and that it will be another positive factor for the long term secular economic growth rate of this country; and, hence, a plus for equity valuations.

Despite the positive impact of deregulation and a potential improvement from better trade deals, the offset is the danger of subdued growth and higher inflation resulting from irresponsible fiscal and monetary policies.  I needn’t be repetitive here; but my bottom line is that

(1)    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 and Street estimates for economic and profit growth will prove too optimistic and valuations will have to adjust when that reality becomes manifest, and

(2)   even worse for the Market is the need for the Fed to normalize monetary policy,   ending QE---which has led to the gross mispricing and misallocation of assets.  That process, 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.  In addition, if Trump’s trade policies prove successful, then a fairer trade system will also have a positive impact on secular growth. 

On the other hand, I believe that fiscal policy will have an opposite effect on economic growth and that monetary policies, sooner or later, will have to correct the mispricing and misallocation of assets---and that will be a negative for the Market.

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 simple: 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 any price strength to sell a portion of my winners and all of my losers.
                As a reminder, my Portfolio’s cash position didn’t reach its current level as a result of the Valuation Models estimate of Fair Value for the Averages.  Rather I apply it to each stock in my Portfolio and when a stock reaches its Sell Half Range (overvalued), I reduce the size of that holding.  That forces me to recognize a portion of the profit of a successful investment and, just as important, build a reserve to buy stocks cheaply when the inevitable decline occurs.

DJIA             S&P

Current 2018 Year End Fair Value*              13860             1711
Fair Value as of 4/30/18                                  13428            1656
Close this week                                               24360            2656

* 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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