Saturday, April 28, 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                     13151-29356
Long Term Uptrend                                  6410-29847
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2488-3259
                                    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 upbeat: above estimates: March new and existing home sales, April consumer confidence, weekly jobless claims, the April Markit flash PMI’s, the April Kansas City Fed manufacturing index, the March trade deficit, first quarter GDP; below estimates: weekly mortgage and purchase applications, month to date retail chain store sales, the March Chicago national activity index, the April Richmond Fed manufacturing index, first quarter employment costs; in line with estimates: March durable goods/ex transportation.

              The primary indicators were also strong: March new home sales (+), March existing home sales (+), first quarter GDP (+) and March durable goods (0).  It is pretty clear that this week was a plus.  Score: in the last 133 weeks, forty-five were positive, sixty-two negative and twenty-six neutral. 

The overseas numbers were mixed to negative.  Most notably, the EU continues to weaken.  As a result, I am altering our forecast, removing it as a source of support for the US economy.

Very little occurred on the political front.  Indeed, the headlines this week were dominated by first quarter earnings reports and concerns over rising interest rate.

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) and could potentially offset any positives from deregulation and trade.

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.  

Wells Fargo is fined another $1 billion for auto and insurance fraud---and no one goes to jail.

(2)   fiscal/regulatory policy.  

Four news items:

[a] apparently, Mnuchin is going to China in the attempt to resolve the trade disputes,

[b] the Treasury department cuts 300 regulations from the IRS code,

[c] Trump is likely to withdraw from the nuclear agreement with Iran and re-impose sanctions which not only has geopolitical implications but also an economic one, specifically, the impact on the price of oil,

[d] there are hopeful signs that a revised NAFTA agreement is close.

 While earnings season and concerns on interest rates held the headlines, the progress in trade talks and the continuing battle against the entrenched government bureaucracy have far greater long term implications for the secular growth rate of this country; those are quite positive.

Having said that, the turd in the punch bowl remains the excessive level of current national debt plus the inane drive to push it even higher

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 higher long term rates will ultimately 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 central bank news this week came from overseas: the ECB met and left rates and its QE policy unchanged.  Somewhat surprisingly given the recent dearth in upbeat economic stats out of the EU, Draghi joined the US dreamweavers painting a future filled with growth.

The Bank of Japan also met and decided that eight years of zero interest rates and the government purchasing anything that even looks like a security just isn’t enough.  Japan needs more.  So it removed the goal posts for ending QE, making the BOJ a prime contender for the Noble Prize for insanity.

Given the lack of success of QE to date, I can’t imagine how more of it will be of any benefit to their respective economies.  On the other hand, more of the same simply adds to the ultimate problem of undoing it.  Clearly, the vast consensus of economists and investors is not worried about this prospect. 

Complicating the issue is that the Fed has already started to unwind US QE, putting our monetary policy at odds with the EU and Japan.  I am not sure how that conflict in monetary policies works itself out in the global asset markets, particularly with respect to the timing of the reversal of the mispricing and misallocation of assets. 

However, I remain convinced that since the major beneficiary of QE was the asset market, then it will likely suffer pain when, as and if QE is unwound.

(4)   geopolitical risks:  The good news is that the US/Russian faceoff in Syria appears to have dissipated, North and South Korea have just reached an agreement to officially end the Korean War and plans for the Trump/Un meeting are moving forward.  The bad news is that the odds of a US/Iran confrontation are growing.

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

[a] the April Markit EU flash PMI’s were upbeat while economic sentiment was in line; the April German business climate index was slightly below consensus; and the UK first quarter GDP was terrible,

[b] March Chinese industrial profits rose 11.6% year over year versus February’s reading of +16.1%.

I am altering the bottom line: Europe has joined the rest of the world struggling to maintain positive economic growth.
            Bottom line:  the US long term secular economic growth rate could improve based on increasing deregulation.  In addition, if the success of the trade negotiations with South Korea can be repeated with NAFTA and China, which appears increasingly likely, then a fairer trading regime would almost certainly be an additional plus for the US long term secular economic growth rate.  ‘If’ remains the operative word; plus we need to see the shape of any new agreement before changing our forecast. 

At the same time, those long term positives are being offset by a totally irresponsible fiscal policy.  The original tax cut, a second proposed new improved tax cut, increased deficit spending and a potentially big infrastructure bill will negatively impact economic growth and inflation, in my opinion. The current level of the national debt and budget deficit are simply too high to allow the additional economic growth.  I believe that a bigger deficit/debt=slower growth and a higher deficit spending=inflation, even if they are the result of a tax cut and/or infrastructure spending.  Hence, this is a negative for the long term secular growth rate of the economy.

It is important to note that the negative impact that a rapidly growing national debt and budget deficit have on economic growth is not just long term in nature.  There is also a short term effect on Fed policy which is being dramatically exacerbated by its own irresponsible venture into QE.  As a result, the central bank has put itself in a no win situation: [a] if I am wrong and the economy accelerates and the Fed does nothing, it risks inflation, [b] in fact even if economic doesn’t pick up, but LIBOR rates continue to blowout and the ten year Treasury pushes through 3%, the Fed may not even have the option of doing nothing, [c] in either event, if it moves forward with the unwind of QE, it will begin the unwinding of the mispricing and misallocation of global assets---which only confirms 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 24311, S&P 2669) had a mixed day (Dow down, S&P up). Volume was flat; breadth was unimpressive.   The S&P ended within a very short term downtrend; though the Dow again closed above the upper boundary of its former very short term downtrend.  That leaves the Averages out of sync with respect to this one indicator, meaning that there is little informational value on direction/momentum.  Both finished below their 100 day moving averages (now resistance) but above their 200 day moving averages (now support).  The DJIA closed 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.  Longer term, the assumption is that equity prices will continue to rise.
                The VIX fell another 5 ¼ %, closing below its 100 day moving average (if it remains there through the close next Tuesday, it will revert to resistance) but above its 200 day moving average and the lower boundary of its short term trading range.  Additional weakness would point to higher stock prices.
The long Treasury rallied ¾ %, pushing further back above the lower boundary of its long term uptrend which it had unsuccessfully challenged on Wednesday.  However, it remains below its 100 and 200 day moving averages and in a short term downtrend---indicating a lot of resistance to a further increase in prices (decline in rates).  (must read):

The dollar paused in its rally, but remained above the lower boundary of its newly reset intermediate term trading range, above its 100 day moving average (now support) and above its 200 day moving average for the second day (now resistance; if it remains there through the close next Tuesday, it will revert to support).
GLD was up ½ %, bouncing off its 100 day moving average, finishing above its 200 day moving average (now support) and in a newly reset short term trading range.

Bottom line: I have noted over the last couple of weeks that the Averages were caught in a narrowing range, bounded on the upside by their 100 day moving averages (plus the S&P’s upper boundary of its very short term downtrend) and on the downside by their 200 day moving averages.  Two Thursdays ago, the Averages challenged that upper boundary and failed.  Wednesday, they challenged the lower boundary and failed.  Now they appear on their way for another challenge of the upper boundary.   Sooner or later that range will be broken; history suggests a strong follow up move in the direction of the break. 

TLT failed its second challenge of its long term uptrend and is now in a two day rally.  But it faces multiple resistance levels.  While the recent increase in the dollar is the usual reaction to the selloff in Treasuries, it has remained upward bound though TLT rallied hard on Thursday and Friday---a little confusing.  Meanwhile, gold’s response was to be expected.  That said, the recent pin action in all the indicators suggests a good deal of investor turmoil/confusion as multiple support/resistance levels are being challenged.

Price instability/uncertainty remains for the moment.  The question is duration.    Patience.  I love my cash.

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’ could be positively impacted based on a new set of regulatory policies which would 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.  On the other hand, a soaring national debt and budget deficit are negatives to long term growth and, hence. ‘Fair Value’.

Moreover, on a short term basis (this week’s data notwithstanding), 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.  I don’t believe that sluggish growth is reflected in the price of stocks.

The two issues that held investor attention this week were:

(1)   the course of interest rates.  As you know, the ten year Treasury toyed with the 3% level for most of the week---3% being a psychological break point for bond investors.  Plus the thirty year Treasury is in the midst of a challenge of its long term [30 year] uptrend.  A breach of these landmarks would portend a continuing rise in rates.  The question is, why are they rising?  Are interest rates rising because the economy is strengthening which would normally be accompanied by an increasing demand for credit and a little inflation; or are they rising because the economy can’t grow any faster and any resources directed at growth are simply driving prices higher.  You know that I believe that the latter is the case---which will not be good for stocks.  But more data is needed before that forecast pans out---if it pans out,

(2)   we are in the thick of earnings season.  As you know, I thought that while anyone with a heartbeat knew the results would be spectacular [as a result of the tax cut], the flow of good news would keep investors enthused.  As it turns out, the earnings reports have been coming in as expected; but investors have not reacted that positively.  I take that to mean that another catalyst is needed to get stocks back on an upward track.  I await the good news.

Meanwhile, my operating scenario is that the positive impact of deregulation and a potential improvement from better trade deals could very well be offset by the likelihood of subdued growth and higher inflation resulting from an irresponsible fiscal policy (expanding the national debt and the budget deficit to the point at which the cost of servicing the debt/deficit negates any benefit from tax cuts or infrastructure spending).  I needn’t be repetitive here; but:  

(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. 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.  Indeed, as I noted above, if long rates continue to rise, it won’t have a choice.  Since QE led to the gross mispricing and misallocation of assets, the process of unwinding it, in my opinion, would not be good for the Markets because they are the only thing that benefitted from QE.
Bottom line: a new regulatory regime plus an improvement in our trade policies should have a positive impact on secular growth.  On the other hand, I believe that fiscal policy will have an opposite effect on economic growth.  Making matters worse, monetary policy, 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                                               24311            2669

* 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.

No comments:

Post a Comment